Electric power generation planning for interrelated projects: a real options approach

Abstract

The market uncertainties in the generation business in the U.S. electric power industry have increased the significance of two factors in generation planning: financial risks and managerial flexibilities. At the same time,numerous utilities have multiple generation planning projects that are interrelated with respect to their market values. For such utilities, in order to quantitatively address these two factors, in this paper, we develop and analyze a real options model for general n interrelated projects. Specifically, first, we derive a unique lattice process that approximates interrelated continuous processes for the evolution of values of projects and options (e.g., selling a constructed project). The steps of the approximation for n projects are presented progressively starting from two projects. Next, based on the lattice process, we investigate the impact of interrelation on the values of options. Then, we provide a backward dynamic programming model for optimal sequential decision making where the decisions are made over the options. Finally, managerial insights and economic implications are illustrated via numerical examples.