Option Games applied to investments in power generation capacity

LOPEZ, S.; BLANCO, G.; OLSINA, F.; BAUM, G.

Manchester

Conferencia; XII IEEE PES PowerTech Conference; 2017

IEEE PES Europe

Because of the still significant economies of scale, the power generation industry typically organize itself as a market under oligopolistic competition. In this type of market structure, the agents implement various strategies or games to exercise market power in order to increase their profits above competitive levels and/or prevent the entry of new agents in the market. During the investment, decision-making process, generation companies must perform timely investments to anticipate their competitors while minimizing costs in risky projects under high exposure to uncertainties. Therefore, the investor should evaluate the investment alternatives considering the flexibility value of embedded options for hedging against unfavorable market scenarios, including strategic movements of competitors. Therefore, it is necessary to develop a hybrid tool that combines Game Theory with Real Options in order to contemplate the entire relevant features of the problem. This tool ?called Option Games- has been recently developed. Despite its enormous potential, this new methodology has not received significant attention in the power market field yet. This paper presents an application of Option Games to the problem of investing in power generation capacity in the context of a duopoly market. Investment alternatives are assessed by its ability to enter the market considering four different investment scenarios in a duopoly game. By using a hybrid model that combines binomial trees of Real Options into payoff matrices of Game Theory, the optimal decision problem can be solved.