Application of option pricing concepts to regulated utility investment decision-making

Flexibility actions of regulated utilities, such as permitting, siting and designing a powerplant prior to need, can reduce the lead-time and/or final costs of an investment and provide important strategic benefits. These actions have the potential of reducing both electric utility risk and total revenue requirements. Regulatory policy, particularly asymmetric regulation and a lack of regulatory commitment, can affect a utility\u27s interest in flexibility and may create disincentives for investment in these actions. To examine regulatory policy towards flexibility, this dissertation develops a model of investment decision-making based on option pricing concepts, and uses this model to examine incentives and disincentives for efficient investment under various forms of regulation. The value of these planning flexibility actions is explicitly modeled as a real option, analogous to a financial option. Both an unregulated and regulated form of this model are developed. The extension of the real options valuation model to regulated firms incorporates cost-of-capital considerations, allowed rate-of-return constraints, and cost recovery options, and represents an advancement in the literature. The policy implications of regulatory treatment of flexibility are analyzed within a welfare economics perspective and through a two-period game. The welfare economics analysis indicates that optimum regulatory policy is dependent on project and regulatory characteristics. Partial or full recovery of completed plant can be welfare optimal, but that full recovery of abandoned plant or options expenditures is never optimal. Nevertheless, if utilities do not expect regulators to keep their commitments, then they will invest based on the assumption of no loss restrictions, and some otherwise efficient investments may not be undertaken, particularly when profit restrictions are active