Deregulation of electricity markets increases the uncertainty about the market environment and firms face investment risks associate with power generation assets. Valuing flexibility of investment projects and the management of project risks are crucial issues for firms to achieve their corporate objectives, such as stable earnings and growth in volatile electricity markets.
If there was no uncertainty in market environments, investing in a large-capacity generating unit would be more profitable than a small-capacity investment because of the economy of scale and high generating efficiency. However, in an uncertain electricity market, a large-capacity generating unit increases investment risks that would be lowered by choosing a set of small capacities of generating units and so starting with a smaller capacity might have some option value related with capital investment flexibility, which is known as capacity expansion option.
The traditional net present valuation is no longer an adequate method of valuing flexibility of investment project of power generation assets and more sophisticated method such as real options analysis is necessary to value the assets in volatile market environments. The real options analysis gives insights into these risks of investing in generating assets.
In this appendix, we show a simple example of real options valuation of the capacity expansion option of CCGT. The Japanese electricity market is taken as an example, though the valuation model may have applicability to other markets.