Chapter 10 Dealing with
Uncertainty
10.1 Introduction
• ---exacerbated by regulatory & environmental uncertainty
• Restructuring of the electric industry, is more complex
than imagined.
• Dealing with uncertainty is crucial.
10.2 Key Issues
1.
2.
3.
How can we make economic decisions in the face of
market and nonmarket uncertainties?
How do we measure uncertainty, especially
uncertainty about nonmarket issues like global climate
change?
How do we determine the value of new information
that might help reduce uncertainty?
• Uncertainty has critical impacts. (price volatility, policy
compromises)
• Development and failure of IRP (integrated resource
planning).
10.3 Making Investment Decisions
Under Uncertainty
• Sensitivity analysis &scenario analysis
• Sensitivity analysis:
“base case” model, adjust inputs individually
• Scenario analysis:
same “base case”, but constructs specific “scenarios”
that can include multiple changes.
Problem for both:
Ignore the likelihood of different events or scenarios; fail to
identify “least-cost” choices.
Table 10.1 Distribution Planning
Costs
Table 10-2: Expected Costs of
Alternative Investment Strategies
Real Options
Let us consider discounted cash flow analysis & the impact
of uncertainty.
Suppose: consider whether to build a new electric
generating plant; output will be sold in the wholesale
market.
• C=$500 million. Produce $1 million MWh per year
• P either $40 per MWh or $80 per MWh,
then P=0.5*$40+0.5*$80=$60
C: cost; P: price; Q: quantity of electricity produced; r:
discount rate
• NPV is positive, but should also consider when P is $40:
• NPV of waiting for one year is:
If P=$40, no investment ( first term 0); if P=$80, invest.
Uncertainty resolved.
---This resembles a call option on a common stock.
The cost of waiting is forgone R if the future turns out well.
Figure: The future Price of
Electricity
• First, calculate the Min. P next year for the investment to
have a positive NPV if we wait:
• This means the initial price, P0, equals P1/1.5=$30. So if
P0< $30, we will never wait to invest in the plant, coz
there is no chance the investment will be profitable.
• Next, determine when the expected NPV of investing
today is greater than expected NPV if waiting:
• P0=$78. So the opportunity cost of waiting will be
greater than the value of the option to wait.
Figure 10-2 :Value of Option to
Invest.
Figure 10-3 Increased Price
Uncertainty
Decision Trees and the Value of
Information
• Decision trees: for making
good decisions and
determining the value of new
info.
• Ex: deciding whether to walk to
work tomorrow or ride the bus.
• Consider: weather
walk
Ride
Bus
Rain
0
6
No
Rain
10
6
• Two decision “branches” and two uncertainty branches
off each decision branch.
• E(walk)=0.5*10+0.5*0=5.0
• E(Bus)=0.5*6+0.5*6=6.0
• So unless gamble on the weather, you should take a
bus.
The Role of Emotions
• Traditional economics assumes rational decision-maker.
• Sometimes, the info needed to make a rational decision
is not available; some decisions are emotional or
political.
• But when it comes to major investment decisions and
regulatory evaluations, role of emotions should be
limited.
Applying Decision Analysis
Techniques to the Electric Industry
Ex: a coal-fired power plant, required to reduce carbon
emissions by 50% starting 5 years from now.
Choices:
1. Shut down the plant
2. Purchase emissions allowances at an unknown future
P
3. Invest in a new experimental technology that is
designed to capture 80% of the carbon emissions and
inject it deep underground.
Regulatory Impacts
• This analysis is also crucial from a regulatory standpoint.
• To ensure prudent investment
• To scrutinize unregulated generators bidding into POLR
auction
10.4 Measuring Price Volatility
• Forecast changes in demand and supply, to ensure that
enough electricity is available to avoid blackouts;
• to evaluate whether market power concerns are likely to
emerge.
• But still can not account for all.
• Volatility, similar to std.dev., but normalized to a specific
time period.
Figure 10-7: Henry Hub Daily
Average Closing Natural Gas
Prices.
•
Measuring volatility is critical for :
determining the value of hedging and the cost of
reducing exposure to uncertain market prices;
capital investment decision.
•
Easiest way to calculate historic volatility:
1.
2.
3.
Calculate the log of day-to-day P changes for entire y
Calculate the std.dev. Of those P changes
Multiply the std.dev. By the square root of the average
number of trading days per y, usually defined as 252.
10.5 Nonmarket Uncertainties
•
Ex: regulatory and political structures, etc.
•
What can be done?
1.
Ignore nonmarket uncertainties or addressing them
crudely (Diff bw risk and uncertainty); determine event
thresholds
Add uncertainty to the decision framework
Complications:
Use judgment; decide how much risk is acceptable;
weigh the risks of different investment strategies
2.
3.
Table 10-4 Critical Event Matrix
Figure 10-8 Comparing Multiple
Projects