Optimal technology adoption for power generation

Abstract

We examine the decision problem of a power producer contemplating an upgrade of its current generation capacity based on a fossil fuel technology (gas plant), when price processes have affine drift and differentiable volatility functions. The operator can choose the best of four mutually exclusive alternatives, continue operating the current technology, replace it by a more efficient fossil fuel technology (gas plant), replace it by a renewable technology (wind plant), and divest (liquidate). There are four corresponding decision regions with three boundaries. Optimal boundaries of regions are characterized through a trivariate system of coupled Fredholm equations and valuation formulas derived. Investing in a more efficient gas plant is optimal if the gas price falls below some threshold and the electricity price exceeds an associated (gas) boundary. For some parameters, the gas price must also exceed a lower threshold. Investing in a wind plant is optimal if the gas price becomes sufficiently high and the electricity price exceeds an associated (wind) boundary. Liquidation is optimal if the electricity price falls below a (liquidation) boundary. The continuation region lies in between these boundaries. The possibility of investing in wind displaces new gas investment and postpones liquidation of the existing gas plant. We study the value of the firm and the Green Energy premium, and assess the impact of model parameters.