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A Real Options Model for Electricity Capacity Expansion

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  • Joachim Gahungu and Yves Smeers

Abstract

This paper proposes a real option capacity expansion model for power generation with several technologies that differ in operation and investment costs. The economy is assumed perfectly competitive and the instantaneous payoff accruing from the generation system is the instantaneous welfare defined as the usual sum of consumer and producer surplus. The computation of this welfare requires the solution of a multi- technology optimization problem and the obtained optimal function value is not additively separable in generation capacities, contrary to what is generally assumed in multi asset real option models to prove the optimality of a myopic behavior. Using the geometric Brownian motion as uncertainty driver we propose two regression models to approximate the instantaneous welfare. A first, additively separable approximation implies the optimality of myopia. The second approximation is non separable and hence forces to take myopic behavior as an assumption. Using myopia as an assumption, we propose a semianalytic method which combines Monte Carlo simulations (used to compute the value of the marginal capacity) and analytical treatment (to solve an optimal stopping problem on a regression scheme).

Suggested Citation

  • Joachim Gahungu and Yves Smeers, 2012. "A Real Options Model for Electricity Capacity Expansion," RSCAS Working Papers 2012/08, European University Institute.
  • Handle: RePEc:rsc:rsceui:2012/08
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    Cited by:

    1. Michail Chronopoulos & Verena Hagspiel & Stein-Erik Fleten, 2017. "Stepwise investment and capacity sizing under uncertainty," OR Spectrum: Quantitative Approaches in Management, Springer;Gesellschaft für Operations Research e.V., vol. 39(2), pages 447-472, March.
    2. repec:eee:dyncon:v:84:y:2017:i:c:p:1-31 is not listed on IDEAS

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    Keywords

    Real options; capacity expansion; power investment; optimal dispatch;

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