How real options analysis can be used to make better network investments

1. HoustonKemp.com
How real options analysis can
be used to make better network
investments
ENA conference presentation
Sam Forrest
Sydney
7th June 2018

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Overview
• What is real options analysis?
• Real options analysis and the RIT-T
• Case study on the Eyre Peninsula Supply Options RIT-T
• Tips for applying option value to electricity network
investments
2

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A scenario requiring real options analysis
• You are seeking to upgrade
deteriorating transmission lines
• You need to determine the appropriate
capacity of the lines to account for
potential future loads
• A large industrial load has expressed
interest in locating on the line in the
future but the outlook remains
uncertain
3
Option 1
Do not build sufficient capacity
Risk of unrealised benefits
or inefficient investment if
the load does eventuate
Option 2
Build sufficient capacity
Risk of stranded asset if
the load does not
eventuate
Option 3
Staged investment
Reach the optimal trade-
off by making smaller
investment in the short
term to create flexibility
Evaluated using real options
analysis

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What is real options analysis?
• Real options analysis is a way of quantifying the costs and
benefits of staged investments by considering future investment
decisions based on future information
• ‘Option value’ is the additional benefit arising from optimised
future decisions
• Option value arises when:
1. significant uncertainty exists regarding the future and the value of the
investment
2. investment decisions can be staged over time
3. future information will become available that will affect the
investment decision
4. this information can be reacted to in a timely manner
• The nature of the analysis can vary substantially depending on
the context
4

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Real options analysis and the RIT-T
• ‘Option value’ was added to the RIT-T in 2009
› AEMC considered that consideration of option value: ‘May
facilitate a more strategic view of projects’
• Option value has not been fully considered in any
RIT-T undertaken to date
• Reasons for this include:
› not applicable to all investment decisions
› implementation challenges, ie, modelling complexity
5

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Application to the Eyre Peninsula RIT-T - Context
6
Existing network configuration
Significant potential mining activity and
potential renewable energy resources are
located on the Peninsula

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Application to the Eyre Peninsula RIT-T –
Preliminary findings
7
Option B
Option C
• Double circuit 275kV from
Cultana to Yadnarie
• Double circuit 132kV from
Yadnarie to Port Lincoln
• Double circuit 275kV (lines)
from Cultana to Yadnarie,
initially operated at 132kV
• Double circuit 132kV from
Yadnarie to Port Lincoln
• Double circuit 132kV from
Cultana to Port Lincoln
Option A
Top three options based on PADR modelling

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Timing and trigger assumptions
• Initial investment decisions are assumed to be made in 2018
• New information on trigger variables is available at two points in time – in 2023 and
2028
• Substation works to upgrade from 132kV to 275kV take 2 years and upgrades can
only occur in response to information available in 2023 and 2028
• Trigger variables were:
› Mining load – whether a mining load greater than 50MW seeks connection to the
network
› SA-specific renewables policy – eg, whether the Eyre Peninsula is designated as a
‘renewables precinct’ and transmission capacity expansion is mandated
• A mining load connects two years after a signed connection agreement and
therefore, aligns with upgrade timing
8
2018 203020242019 2020 2021 2022 2023 2025 2026 2027 2028 2029
Initial
decision
Construction
complete
Decision
point 1
Upgrade 1
completion
Decision
point 2
Upgrade 2
completion

9. HoustonKemp.com 9
etc
2018
SA Renewable Policy No Pr =0.5
Mining Yes Pr =0.2
Upgrade North Yes
Upgrade South No
Pr=0.1
SA Renewable Policy Yes Pr =0.5
Mining North Yes Pr =0.2
Upgrade North Yes
Upgrade South Yes
Pr=0.1
2023
Information on trigger
variables is observed
Information revelation and upgrade decisions
Initial
investment
decision made
Upgrade decisions are
made based on trigger
variables
Repeat for each combination of scenario variables

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Interactions between option value model and
wholesale market model
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2018
SA Renewable Policy No Pr =0.5
Mining Yes Pr =0.2
Upgrade North Yes
Upgrade South No
Prtrigger=0.1
2023
Extract wholesale market modelling
results based on scenario and trigger
variables and weight the result by the
probability (Prscenario x Prtrigger)
Scenario:
Run Demand Gas Mining
2018
Mining
2023
Mining
2028
Upgrade
2018
Upgrade
2023
Upgrade
2028
Investment
Benefits
Dispatch
Beneftis
Other
Benefits
1 Strong High No No No No No No … $XX $XX $XX
2 Strong High No No No No Yes Yes … $XX $XX $XX
3 Strong High No No No No No Yes … $XX $XX $XX
4 Strong High No Yes Yes No No No … $XX $XX $XX
5 … … … … … … … … … … … …
Database of wholesale model run results
Demand High Pr =0.33
Gas price Neutral Pr =0.33
Prscenario=0.11

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Tips for applying real options analysis to network
investments
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Develop decision rules
or investment triggers
Adjust numbers of
decision points to
control complexity
Be aware of interactions
with other modelling
Segment the investment
decision into clear
discrete decisions
Develop decision rules or investment triggers to reduce
analysis complexity, eg, the network would need be
expanded if a new load eventuates
Often option value analysis requires inputs from other
complex modelling and so consider simplifying
assumptions where possible, eg, consider less granular
wholesale market modelling
The complexity of the modelling increases exponentially
with the number of decision points, and so this is one of
the key levers for controlling complexity
Clearly defining discrete investment stages and feasible
staging options ensures that the analysis remains
tractable
Decide if real options
analysis is the right
approach
Option value is not always relevant or significant so use
‘back of the envelope’ type analysis to identify whether
option value is material

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