Real Options and Transmission Investment: the New Zealand Grid Investment Test Glenn Boyle, Graeme Guthrie and Richard Meade EPOC Winter Workshop University of Auckland 7 September 2006 Richard Meade Research Principal, ISCR Principal, Cognitus Advisory Services Limited Teaching Fellow, Victoria University SEF and Management School

Electricity Commission (EC) now approves Transpower’s grid investments EC has developed a grid investment test (GIT) for proposing, reviewing and approving grid investments GIT has three steps: –Identify market development scenarios –Estimate “net market benefit” (NMB) of investment under each scenario: “Market benefit” = PV of benefits to users and suppliers over 20 years Cost = PV of investment’s cost to users and suppliers over 20 years –Calculate E(NMB) as probability-weighted average across scenarios Investment satisfies GIT if: –E(NMB)>0 AND –E(NMB of proposed investment) > E(NMB of feasible alternatives) Background

GIT permits the use of ROA, without being prescriptive ROA values the flexibility inherent in many investments to change plans in response to new future information, i.e. to either: –Improve returns –Reduce losses It thus extends/complements standard NPV analysis ROA is useful when: –Investments are irreversible –Key future decision variables are uncertain –That uncertainty is financially material –Investment is flexible See (e.g.) Dixit and Pindyck, Investment Under Uncertainty, 1994 Real Options Analysis (ROA) – cont’d

Simple ROA – Invest Big or Small? Investment PossibilityProject NPV (a) Single 400 kV now (b) Single 220 kV now (c) Two 220 kV’s in a row (d) Single 220 kV now + possibly another later Consider a two period investment (220 kV or 400 kV), discount rate r:

Invest Big or Small? – cont’d Investment PossibilityProject NPV (a) Single 400 kV now (b) Single 220 kV now (c) Two 220 kV’s in a row (d) Single 220 kV now + possibly another later Consider a two period investment (220 kV or 400 kV), discount rate r: Value of expansion option (≥0)

Invest Big or Small? – cont’d Now the NPV of “220 kV now and maybe one later” can be rewritten as: NPV of two 220 kV’s in a row Value of abandonment option re 2 nd 220 kV (≥0) Hence only sensible to compare immediate 400 kV investment (i.e. a) with immediate 220 kV investment and possibility of a second (i.e. d), allowing for the possibility of the second line’s abandonment

Invest Big or Small? – cont’d Rearranging the RHS, immediate 400 kV investment is preferred iff: Value of scale economies Value of abandonment option that is destroyed by a larger (rather than staged) investment Thus a simple ROA identifies a trade-off between earlier receipt of scale economies, and investment flexibility

Any decision to delay transmission investment is affected by: –Availability of alternatives, and –Speed of resolution of uncertainty Suppose that if no line is built now, either a 400 kV or a 220 kV line must be built later StrategyStrategy NPV Do nothing now and invest in grid later Invest in transmission alternative now (with NPV=G) and grid later An Extension – Transmission Alternatives

Any decision to delay transmission investment is affected by: –Availability of alternatives, and –Speed of resolution of uncertainty Suppose that if no line is built now, either a 400 kV or a 220 kV line must be built later StrategyStrategy NPV Do nothing now and invest in grid later Invest in transmission alternative now (with NPV=G) and grid later An Extension – Transmission Alternatives Assuming G>0

Transmission Alternatives – cont’d Immediate 400 kV investment is preferred to this strategy iff: Net benefit of committing to 400 kV now versus grid alternative now kV later Value of switching option (i.e. to 220 kV from 400 kV) that is lost by committing to 400 kV now

Transmission Alternatives – cont’d Similarly, immediate 220 kV investment is preferred to this strategy iff: Net benefit of committing to 220 kV now versus grid alternative now kV later Value of switching option (i.e. to 400 kV from 220 kV) that is lost by committing to 220 kV now, net of value of expansion option re second 220 kV line

Time to build – decision complicated by uncertainty in planning and construction times: –Waiting defers expenditure and allows investment decisions to be based on further information –BUT waiting risks loss of option to choose projects having long or uncertain lead times Uncertainty in planning times also increases value of planning for multiple projects (to be measured net of incremental planning costs) More Extensions

Using this simplified ROA framework (e.g. ignoring generation and transmission coordination): If there is significant uncertainty in future grid demand, incremental investments (or investments that defer grid investments), are to be preferred over larger committed investments This result can obtain even though there are economies of scale in grid investment It must be tempered, however, when there are uncertainties in planning and construction times, which: –Reduce the value of the option to defer investment, and –Encourage parallel planning for multiple investments Conclusions