Infrastructure Investment Under Uncertainty: Reconciling Private and Public Incentives

Abstract

Private companies (PCs) in restructured infrastructure industries, e.g., energy and transportation, determine facility investment timing and sizing. Such decisions maximize the PC's expected profit (rather than social welfare) under uncertainty. By anticipating the PC's incentives, a welfare-maximizing transmission system operator (TSO) shapes the network to align public and private objectives. Via an option-based approach, we first quantify welfare losses from the PC's and TSO's conflicting objectives. We show that by anticipating the optimal decisions of the profit-maximizing PC, the TSO is able to reduce welfare loss. In this setting, however, the TSO is still not able to enforce the social optimum under substantial market volatility. Next, we exploit the dependence of the PC's capacity on the TSO's infrastructure design to devise a proactive transmission-investment strategy. Hence, we mitigate welfare losses arising from misaligned incentives even in relatively uncertain markets.