Strategic Decision-Making of Flexible Investments under Uncertainties in Long-Term Electricity Markets

Abstract

In liberalized electricity markets, the investment postponement option is deemed to be decisive for understanding the addition of new generating capacity. Basically, it refers to the investors’ chance to postpone projects for a period while waiting for the arrival of new and better information about the market evolution. When such development involves major uncertainties, the generation business becomes riskier, and the investors’ “wait-and-see” behavior might limit the timely addition of new generation capacity. The literature provides solid empirical evidence about the occurrence of construction cycles in the deregulated electricity industry. However, the strategic flexibility inherent to defer investments in power plants has not been yet rigorously incorporated as an explicit input for investment signals in the revised long-term market models. Therefore, this paper proposes a new methodology to assess the long-term development of liberalized power markets based on a more realistic approach for valuing generation investments. The proposal is based on a stochastic dynamic market model, built upon a System Dynamics simulation approach. The model considers that the addition of new generation capacity is driven by the economic value of the strategic flexibility associated to defer investments under uncertainties. The value of the postponement option is quantified in monetary terms by means of Real Options analysis. Simulations explicitly confirm the cyclical behavior of the energy-only market in the long-run, as suggested by the empirical evidence found in the literature. Furthermore, the proposed method is used to test three regulatory schemes, implemented in order to dampen the arising construction cycles. Results show that, for ensuring the supply security in markets under huge uncertainties, investors would need complementary capacity incentives in order to deploy power generation investments in timely manner.