Risk calculation of an economic transmission project using Kolmogorov equations

TLDR: The method views the investment decision as an option that can be exercised before the optimal condition at which the expected return is maximized under uncertainties and the probability of not recovering the capital investment associated with an early exercise of the option to build before the ideal condition is reached is calculated using Kolmogorov forward equation.

Abstract: Merchant transmission projects are market based projects for importing cheap power from inexpensive power suppliers. Due to uncertainties in the energy market, market based cost recovery mechanisms have not been successful in guaranteeing full recovery of the investment cost. As a result, a regulated recovery via approved transmission rate is likely to be needed. In a previous paper, a method to apply perpetual option theory was proposed to allow an investor to decide when best to invest based on a cost recovery via regulated rate. The proposed method views the investment decision (e.g., construction of a new transmission line) as an option that can be exercised before the optimal condition at which the expected return is maximized under uncertainties. This paper is an extension of that paper. The probability of not recovering the capital investment associated with an early exercise of the option to build before the optimal condition is reached is calculated using Kolmogorov forward equation. The risk of an early exercise is needed for investment decision and for assessing the incentive needed to make the much needed transmission investment.