Capacity Payments and Renewable Portfolio Investments: A Real Options Approach

The ongoing energy transition is increasing the share of renewable energy sources in electricity systems, raising concerns about resource adequacy and long-term investment incentives. Given the intermittent nature of renewable generation, investors face significant uncertainty related to electricity prices and production variability, which may influence investment timing and portfolio composition. In several liberalized electricity markets, capacity mechanisms have been introduced to mitigate these risks and ensure sufficient generation capacity. This paper evaluates how capacity payments and portfolio complementarities between renewable sources influence investment decisions under uncertainty. A real options analysis (ROA) framework is developed to model the option to defer investments in hydropower, wind power and combined hydro-wind portfolios. The model incorporates uncertainties related to electricity prices and generation output and is implemented using a binomial lattice approach with consolidated volatility estimates. The methodology is applied to the Brazilian electricity market (BEM), which is undergoing a liberalization process and preparing new capacity auctions. Results show that complementarities between hydropower and wind generation reduce investment risk and lower the option value of waiting. Diversified renewable portfolios allow investors to participate more competitively in capacity auctions while remaining resilient to market volatility, improving the effectiveness of capacity remuneration mechanisms.