Valuation of a sequential compound option considering electricity generation and transmission expansions

Abstract

An integrated model considering both generation and transmission expansions is needed for long-term planning in the electrical sector because of the interlinked nature of these decisions. Our paper presents a sequential compound option framework to assist decision-makers in the electric power industry in evaluating generation and transmission expansion investments. By incorporating electricity demand uncertainty into the decision-making process, this framework offers a structured approach for assessing short-term generation decisions and long-term transmission decisions in a coordinated manner. Assuming electricity demand follows geometric Brownian motion (GBM), we employ a binomial lattice model to map uncertain demand and evaluate the value of the compound option. The locational marginal price (LMP), which reflects the physical constraints of the power network, is used as the basis for valuation in our model, and reductions in LMP resulting from expansions serve as the measure of project benefit. This integrated approach enables decision-makers to assess the feasibility of generation and transmission expansion projects within a unified framework and determine the optimal timing for exercising the underlying options.