A Review of Optimal Investment Rules in Electricity Generation

Abstract

This paper provides an introduction to optimal investment rules in electricity generation. It attempts to bring together methods commonly used in practice to assess electricity generation investments as well as the sophisticated tools developed by mathematical economists in the last 30 years. It begins with a description of the fundamentals of the problem (economic context of the energy and electricity sectors, the technical constraints and cost structures of generation technologies). In a second part it recalls the investment rule based on the positivity of the net present value (NPV) together with the standard tools of corporate finance needed to perform this evaluation (CAPM, WACC). This list is completed with the more specific tool of levelised cost of electricity (LCOE) used by electrical utilities and policymakers. The third part of the paper shows how the advances made in the last quarter century by economic theory mainly under the real options trademark challenged the standard investment rule. Using intensively stochastic control theory and its connection with partial differential equations, real options theory was able to assess the effects of key drivers of investment decision: uncertainty, time to build, competitive pressure and strategic interactions. The paper presents models that provided a breakthrough in the analysis of the impact of each of these drivers on investment decision rules. Despite this interest, the conclusion points out remaining obstacles for the adoption of these methods by financial divisions, mainly but not only their high level of technicity. Research guidelines that could help fill this gap are suggested.