The Value of Capacity Sizing Under Risk Aversion and Operational Flexibility
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IEEE TRANSACTIONS ON ENGINEERING MANAGEMENT
1
The Value of Capacity Sizing Under Risk Aversion and Operational Flexibility
Michail Chronopoulos, Bert De Reyck, and Afzal Siddiqui
Abstract—Risk aversion typically erodes the value of an investment opportunity, often increasing the incentive to delay investment. Although this may be true when the decision maker has discretion only over the timing of investment, any additional discretion over the capacity of a project may lead to different results. In this paper, we extend the traditional real options approach by allowing for discretion over capacity while incorporating risk aversion and operational flexibility in the form of suspension and resumption options. In contrast to a project without scalable capacity, we find that increased risk aversion may actually facilitate investment because it decreases the optimal capacity of the project. Finally, we illustrate how the relative loss in the value of the investment opportunity due to an incorrect capacity choice may become less pronounced with increasing risk aversion and uncertainty.
Index Terms—Capacity sizing, energy sector, real options, risk aversion. I. INTRODUCTION
PART from discretion over the timing of investments, a firm typically also has the freedom to determine the scale of a project, i.e., in the form of installed capacity. By adopting a high capacity, the firm may be unable to cover the investment cost in the case of an unexpected downturn, whereas if the firm installs a low capacity, then it may end up forgoing revenues if market conditions suddenly become favourable. Consequently, choosing the correct capacity is crucial particularly when the expansion or contraction of an investment project after its initial installation is too costly, which may be the case in the electric
power
IEEE TRANSACTIONS ON ENGINEERING MANAGEMENT
1
The Value of Capacity Sizing Under Risk Aversion and Operational Flexibility
Michail Chronopoulos, Bert De Reyck, and Afzal Siddiqui
Abstract—Risk aversion typically erodes the value of an investment opportunity, often increasing the incentive to delay investment. Although this may be true when the decision maker has discretion only over the timing of investment, any additional discretion over the capacity of a project may lead to different results. In this paper, we extend the traditional real options approach by allowing for discretion over capacity while incorporating risk aversion and operational flexibility in the form of suspension and resumption options. In contrast to a project without scalable capacity, we find that increased risk aversion may actually facilitate investment because it decreases the optimal capacity of the project. Finally, we illustrate how the relative loss in the value of the investment opportunity due to an incorrect capacity choice may become less pronounced with increasing risk aversion and uncertainty.
Index Terms—Capacity sizing, energy sector, real options, risk aversion. I. INTRODUCTION
PART from discretion over the timing of investments, a firm typically also has the freedom to determine the scale of a project, i.e., in the form of installed capacity. By adopting a high capacity, the firm may be unable to cover the investment cost in the case of an unexpected downturn, whereas if the firm installs a low capacity, then it may end up forgoing revenues if market conditions suddenly become favourable. Consequently, choosing the correct capacity is crucial particularly when the expansion or contraction of an investment project after its initial installation is too costly, which may be the case in the electric
power
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