Optimal Decision-Making under Uncertainty - Application to Power Transmission Investments

Abstract

Investment could be defined as the act of incurring immediate costs with the expectation of future returns. An investment project, as every asset has a value. Thus, for successfully investing in and managing these assets is crucial not only recognizing what the value is but also the sources of this value (Damodaran, 2002). Most investment decisions share three important characteristics in different degrees. First, investments are partially or totally irreversible. Roughly speaking, the initial investment cost is at least partially sunk; i.e. it is impossible to recover all the expenditures if the decision-maker changes her mind. Second, there is uncertainty in the revenues from the investment, and therefore, risk associated with this. Third, all decision-making has some leeway about the timing of the investment. It is possible to defer the decision making to get more information about the future. These three features interact to determine the optimal decisions of investors on a given investment project (Dixit & Pindick, 1994). Transmission utilities are faced with investments, which hold these three characteristics significantly: irreversibility, uncertainty and the choice of timing. In this context, an efficient decision making process is, therefore, based on managing the uncertainties and understanding the relationships between risks and opportunities in order to achieve a welltimed investment execution. Therefore, strategic flexibility for seizing opportunities and cutting losses contingent upon the market evolution is of huge value. Strategic flexibility is a risk management method that is gaining ongoing research attention as it enables properly coping major uncertainties, which are unsolved at the time of making decisions. Hence, valuing added flexibility in transmission investment portfolios, for instance, by investing in power electronic-based controller meanwhile transmission line projects are deferred, is necessary to make optimal upgrading. However, expressing the value of flexibility in economic terms is not a trivial task and requires new, sophisticated valuing tools, since the traditional investment theory has not recognized the implications of the interaction between the three aforementioned investment features. Any attempt to quantify investment flexibility almost naturally leads to the concept of Real Options (RO). The RO technique provides a well-founded framework -based on the theory of financial options, and consequently, stochastic dynamic programmingto assess strategic investments under uncertainty (Trigeorgis, 1996).