- 1 -

Flexible Investment Decisions in the European

Interconnected Transmission System

G. Blanco
1
, D. Waniek
2
, F. Olsina
1
,

F. Garcs
1
and C. Rehtanz
2

1
Instituto de Energa Elctrica, Universidad Nacional de San Juan, Argentina
2
Institute of Power Systems and Power Economics, Technische Universitt Dortmund, Germany

AbstractInvestment decisions in the electricity transmission system are subject to large uncertainties due to high
investment volumes and long planning horizons. Especially in an interconnected system like in Europe, the impact of
different influencing factors on the decision making process is hard to estimate. In the presented approach, stochastic
simulations incorporate the uncertainties like the development of fuel costs and demand growth. The resulting
operation plan of the available power plants and the respective utilization of the transmission network are obtained
by calculating the (least-cost) optimal power flow. The performance of possible network upgrades under uncertain
scenarios is evaluated by applying a real options approach based on Monte Carlo simulations. The focus of the
presented work concentrates on the strategic flexibility that FACTS devices can offer in order to cope with the
uncertain development of the circumstances. A case study for the cross-border connection between Germany and the
Netherlands shows the applicability of the presented approach.

Index TermsFACTS, flexibility, interconnection, investment, optimal power flow, real option, uncertainty
1 Introduction
The economic integration all over Europe of the past decades was primarily based on the creation of common
markets, in which the member countries of the European Union are able to trade their goods without borders.
Similarly, the liberalization of the European power markets almost simultaneously occurred, seeking for the
creation of an Integrated Electricity Market as one of its main objectives. Nevertheless, the effective integration
of these markets faces quite different barriers, which are mainly defined by technical constraints of the
transmission infrastructure [1].
This scenario of integration has raised notably the cross-border power transfers by leading permanent
transmission congestion situations in several interconnection corridors among member countries. This
significantly decreases the integration level of the regional power markets as well as the network reliability. The
- 2 -
blackout in Europe on 4th of November 2006, which affected about 15 million households, has already shown
these impacts [2]. This situation is further aggravated by the increment of installed wind capacity, leading to new
challenges for the operation of the transmission system. Especially the produced electrical energy of large
offshore wind farms has to be transported on long distances to the load centres. In addition, the regional and
temporal mismatch of generation and load due to the fluctuations of the actual feed-in from wind energy
converters adds complexity to the transaction settlement as well as to the congestion forecast.
These bottlenecks require congestion management methods to operate the electric system in an efficient and
reliable way. For example, auction, re-dispatch and counter-trade are congestion management techniques used to
relieve congestions. However, these methods provide a short-term solution. Consequently, additional measures
are necessary in order to ensure sustainability of the electricity markets. In this context, transmission investments
seem to be needed for relieving congestion in the mid- and long-run, where the efficiency of these grid
reinforcements can be quantified by the system-wide economic welfare which corresponds to the difference
between the cost saving on the generation side, energy non-supplied and the investment costs on the network
side [3].
Nevertheless, a progressive adaptation of the transmission grid infrastructure is not an easy task due to the
economies of scale and lumpiness
1
of transmission line investment, increasing the possibility of over- or under-
investment scenarios significantly. On the other hand, transmission investments are normally neither able to be
employed in different applications nor to be sold out without assuming significant losses if circumstances turn
out to be adverse. In fact, the decision of building a new transmission line can be considered as an irreversible
decision. Due to the aforementioned characteristics, large and infrequent transmission projects with low
adaptability are quite usual, having an elevated level of exposure to ongoing key uncertainties in power markets,
e.g. future electricity demand, fuel costs and generation investments.
In addition, the theory and tools for valuing transmission investments are still below the practical needs of
the new power markets. This situation is singularly true in aspects such as the flexibility and the penetration of
flexible transmission devices in the new power markets [4].
Under such risky scenario, the reinforcement grid plans need enough flexibility to quickly adapt to unlikely
scenarios, seizing opportunities or cutting losses according to the development of the uncertainties. This
flexibility should contain several contingent strategies at different stages of the expansion horizon, such as the

1
Lumpiness refers to having to buy an integer number of transmission lines selected from a small set of available capacities, but it is better
understood as simply referring to a cost function with a fluctuating slope [5].
- 3 -
options to defer, expand, contract or even abandon the project. In this context, strategic flexibility to adjust to
changing market conditions has a considerable value [6], which has to be considered during the decision making
process. The real options approach is a risk management method that is increasingly gaining research attention
[7], as it allows properly managing uncertainties, which are unresolved at the time of making investment
decisions.
The incorporation of electronic-based devices, such as FACTS controllers, in the transmission expansion
portfolios could significantly improve its strategic flexibility. In this sense, options such as deferral transmission
lines, resale of the electronic components, operational flexibility, or relocation of the device offer an additional
value to FACTS investments. Some contributions have recently been made in this area [3], [8], [9], [10].
However, these papers apply investment decision rules based on the Net Present Value appraisal (NPV), and
therefore, either contemplate or quantify the flexibility value of the FACTS.
This work is an extension of a previous research presented by the authors in [11] and its aim is to present a
method for assessing flexible investments in the European interconnected transmission system under uncertain
scenarios. This paper takes FACTS devices into account, which add flexibility to the investment portfolio
through new strategic options such as relocation and abandon. These investment alternatives are evaluated
according to the real option method by applying the Least Square Monte Carlo (LSM) approach [12]. The
proposed methodology is applied in a study case which evaluates an interconnection reinforcement at the
German-Dutch border, by showing how the valuation of flexibility is a key task for making efficient and well-
timed investment in the transmission network.
2 Model and Data
The present ENTSO-E system can be expanded by alternative reinforcement measures. Their impact on the
transmission capacities, and consequently, on the generating unit commitment are quantified by a market
simulation based on an optimal dispatch model. The uncertainties of development of fuel prices and load growth
are considered by stochastic simulation as well as investments into new power plants by scenario analysis.
Finally, the saving of generation costs and the additional network costs can be compared by taking into account
the flexibility value and a list of preferred reinforcements can be sorted.
2.1 Network model
The optimal power flow calculations are performed on a reduced network model which is developed to
reproduce realistic situations of the transmission system in the Central Western European (CWE) region
- 4 -
(Belgium, France, Germany, Luxembourg, and the Netherlands). To take possible loop-flows into consideration,
also nodes in Austria, the Czech Republic, Poland, and Switzerland are modelled. The detailed features of the
sample network and the utilized data are described in [13] for the German system. Figure 1 gives an overview of
the structure of the network model. In the German part, the 31 nodes are also allocated to the 16 federal states.
This information is useful as relevant statistical data are often differentiated among the federal states. These data
comprise current and expected values of installed capacity in renewable energies like wind energy, photovoltaic,
biomass, etc. as well as the use of combined heat and power. Another important input for the modelling is the
development of the population which is correlated to the electric load.
Niederlande
Frankreich
Belgien
Deutschland
FR
DE
DE
BE
BE
FR
FR
FR
NL
NL
NL
NL
NL
NL
DE
DE
DE
DE
CH
CZ
CH CH
AT
CZ
PL
PL
SE
DK
DK
BE
BE
Germany
Netherlands
Belgium
France

Fig. 1. Structure of the network model.
The model accuracy of the other considered regions and markets is nearly the same as for Germany although
the focus of the entire model are the implications for the German market and the transmission system, e.g. line
loadings or necessary network upgrades. The numbers of nodes of the other regions are the following:
- Belgium: 4 nodes;
- France: 13 nodes;
- The Netherlands: 9 nodes.
Luxembourg is not modelled explicitly as its main part is associated to the German control area and it does
not have an own power exchange. Besides the network topology and the load situation, the feed-in from
conventional power plants and its future development is essential for the analysis of possible congestions. For
the present situation a detailed dataset of the power plants in the modelled regions is available. The included
- 5 -
units can be differentiated by installed capacity, fuel type, and age. With the help of geographical information,
these units are assigned to the nodes of the sample network.
The net generating capacity of the conventional power plants in Germany is nearly constant until 2020 with
increasing capacities in hard coal and natural gas fired plants. This is mainly due to the abandonment of nuclear
energy which is currently again under discussion and might be delayed. Apart from that, the use of renewable
energies, especially wind energy, it is expected to increase further. The intermittent in-feed is modelled with
different situations which are explained later on.
TABLE I
DEVELOPMENT OF THE POWER PLANT MIX IN GERMANY (IN GW).
2007 2010 2015 2020
nuclear 20.5 16.5 13.0 1.3
lignite 20.5 22.6 22.0 22.0
hard coal 30.5 33.0 34.6 32.8
natural gas 25.3 27.8 33.6 42.8
total 96.8 99.9 103.4 98.9
2

2.2 Stochastic Simulation of the Transmission Investment in Power Markets
In the framework of this work, the generation cost saving is used as the measure to evaluate the performance
of economic network upgrading. Therefore, a market model is necessary in order to replicate the behaviour of
the market players and to estimate the production cost in both scenarios, with and without the proposed
investment. In this work, a DC Optimal Power Flow (OPF) is conducted in order to estimate the optimal
generation cost in both scenarios. The OPF model has been widely used in many pool-based deregulated
electricity markets to calculate the generation dispatch based on the bids submitted by generators and loads, also
taking into account the network constraints. The most usual objective is to maximize the social welfare or to
minimize the generation cost if loads are inelastic. Obviously, the OPF calculation neglects some characteristics
of the real market behaviour within the regarded system. For example national borders and the respective cross-
border trading cannot be regarded explicitly but is incorporated by the capacity limits of the lines. The advantage
of the OPF calculation is that the results represent the true value of network upgrades irrespective of the actual
market behaviour. For the minimization of the generation cost, the optimization problem can be stated
mathematically as follows:

2
The expected decrement of the generation capacity is accompanied with the rising share of renewable generation, which are not listed in the
table.
- 6 -

( )
,min ,max
min max
min
0
. .

l
i
g g
i g
i i i
g d
g d l
i i i
g g g
l l l
C P
P P F
s t P P P
F F F
l
l
l
l
l
'
1
=
1
1
1
1
1
1
1
_ _
!
1
1
1
1 _ _
1
1
1
1+
__
_ _ _
(1)
where
g
C is the supplier bid curve as well as
i
g
P and
i
d
P are the power generated and demanded by unit g and
customer d, respectively at node i. The flow in all lines connected to node i is denoted by
l
F . The operation
limits of each generator unit are stated by
,min,max i
g
P and the network constraints are set by
min,max
l
F .
The stochastic behaviour of the power market model assumed in this work can be characterized as a
fundamental or bottom-up model, since annual generation costs are directly influenced by the long-term
stochastic movements of fuel cost and demand. Therefore, a large number of samples are necessary to perform
Monte Carlo simulations with accurate statistical estimations.
Within the economical point of view, the stochastic cash flow, defined by the annual generation cost saving
for each realization, is used in order to evaluate the performance of the transmission investment. Setting the
investment cost, stochastic discounted cash flow calculations are performed. Finally, real option techniques are
applied for adding the flexibility value of each investment alternative, and the optimal investment decision can
be identified.
2.2.1 Load growth modelling
Load demand growth is the major driver of investments in power systems. Usually, aggregated power
demands are modelled to be price-inelastic, which replicate the lack of control of electrical customers over their
consumption at a short notice. Although the load is considered price-inelastic, a typical assumptions is
considered that the customers will not be willing to consume any energy if the spot price rises above the cost of
being curtailed. This cost, also referred as, value of loss load (VOLL), is generally established by policy-makers
in order to account for scenarios with power shortages because the available generating capacity is not enough
for completely supplying the inelastic demand.
A consistent stochastic load model should be composed for some deterministic patterns as well as stochastic
fluctuations around this deterministic component. To avoid unnecessary complexity, this certain component of
the load model is used to be modelled as an annual drift, commonly characterized as growth in an annual basis.
The random deviations of the growth rate around the expected values of the annual drift, interpreted as an error
- 7 -
of forecasted growth, are commonly assumed to Gaussian according to the Central Limit Theorem by
following a generalized Wiener process. This process might be formulated as shown below:
dz dt = (2)
where the variation in the variable z during a short period t ^ is defined by the product of a random variable
and the square root of the period length. is so-called white noise, i.e. a independent and identically distributed
(i.i.d.) random variable which has a Gaussian distribution with an expected value equal to 0 and a variance of 1.
Then, the stochastic model of the demand growth rate
i
dR , along an interval dt, can be represented by a
generalized Brownian Motion according to the following expression:

( )
L L
i i
dR t dt dz j o = (3)
where
i
L
j is the estimated unconditional mean load growth rate for the year t,
2
i
L
o the estimated unconditional
variance for this time interval and dz the Wiener process.
Within this work, the demand growth of the German power system is taken as an uncertain variable. The
demand growth within the other regarded countries are taken as covered by new local generation, this is due to
the lack of information about the generation capacity expansion in those countries. Nevertheless, a stochastic
fluctuation around this null growth is taken into account, representing the possible inability of new generation
entrance. The parameters used into the stochastic process are exposed in Table II.
TABLE II.
DEMAND GROWTH PARAMETERS [14].
Country
(0)
[%]
i
peak
L
j

peak
L
i
o
(0)
[%]
i
base
L
j

base
L
i
o
Germany 1.5 0.15 1.5 0.1
Other countries 0 0.1 0 0.1

2.2.2 Generation cost modelling
The main impact of a transmission investment on the social welfare is reflected as generation cost savings by
bringing down the network-related system operational costs such as out-of-merit generation costs caused by
network bottlenecks. Fluctuations of the transmission investment performance, according to this benchmark, are
mainly related to generation cost fluctuations of the thermal units, which are strongly correlated with their own
fuel prices. Commonly, the average marginal cost of generation of the unit generator g at each instant t, denoted
as ( )
g
MC t , can be derived from the average thermal efficiency
g
j and the prevailing fuel prices
F
g
p at that
moment:
- 8 -

( )
( )
F
g
g
g
p t
MC t
j
= (4)
Therefore, the uncertainty over the generation cost savings are strongly linked with fuel price uncertainties. A
reasonable and realistic way to replicate the uncertain evolution of the fuel prices is through a mean-reverting
stochastic process [17]. A mean-reverting process is one where the stochastic paths evolve fluctuating around a
known long-run mean. The simplest mean-reverting process, called Ornstein-Uhlenbeck stochastic process, is
expressed below:

( )
ln ( )
ln ( ) ln ln ( )
F
g
p t
F F F
g g g
d p t p p t dW c o
1

=

( )
(5)
where o is the speed of reversion to the mean,
ln ( )
F
g
p t
o is the volatility of natural logarithmic of fuel prices, and
F
g
p is the normal level of the natural logarithmic of fuel price ( )
F
g
p t , i.e. the level to which
F
g
p tends to
revert
3
.
The historical as well as the forecast data [15] on costs and prices have been used to estimate the numerical
parameters of eq. (5). These parameters are listed in Table III. In the simulations, nuclear fuel cost prices are
assumed constant over the time horizon. The main fundamental of this assumption is based on the fact that the
uranium cost is only a small fraction of the total variable cost (around 5%) in nuclear plants and the deviations
around the expected value are quite narrow in comparison to the fossil fuel price fluctuations [16].
TABLE III.
MEAN REVERSION PROCESS PARAMETERS
Fuel
Type
(0)
F
g
p
/MW
F
g
p

/MW
ln ( )
F
g
p t
o
%

Gas 12.46 17.94 0.129
Oil 20.99 28.21 0.3
Coal 5.51 6.64 0.14

2.2.3 Weighting of the regarded wind scenarios
In order to reduce the number of calculated situations for each realization and each year, two load situations
(base load and peak load) and three wind situations are taken into consideration. The probability of occurrence of
each wind situation is determined according to the empirical histogram shown in Figure 2.
The underlying data are actual values of the wind feed-in in Germany during the year 2006 in a 15 minute
resolution. The overall installed capacity in Germany is around 19.5 GW. The histogram is divided in three

3
Instead of formulating the mean-reversion process in the prices themselves, it should be formulated in the logarithms of prices for ensuring
that electricity prices are always positive [17].
- 9 -
sections. The first section on the left side, low wind, comprises 50% of all values. The next 30% of the values are
in the second section, medium wind, and the remaining 20% represent a high wind condition.

Fig. 2. Weighting of the calculations based on the frequency distribution of the wind feed-in.

The actual wind feed-in that is used in the calculations is defined as the median in these three sections. With
the assumption that 70% of the year can be represented by a base load situation, the matrix shown in Table IV of
the six possible combinations is obtained. Therefore, for each realization and each year six situations are
calculated and weighted according to their probability of occurrence to get representative results of one year.
TABLE IV.
WEIGHTING OF THE WIND FEED-IN SCENARIOS.
low
wind
(lw)
medium
wind
(mw)
high
wind
(hw)

peak load
15 % 9 % 6 % 30 %
base load
35 % 21 % 14 % 70 %

50 % 30 % 20 % 100 %
wind power
feed-in
6 % 19 % 46 %

2.2.4 Modelling of pumping storage units
The complexity in the modelling of pumping storage units results from the interdependency of the pumping
and generating process. Units without any natural inflow can only generate that amount of electricity that was
stored before, taking into account the limited process efficiency. In the presented approach, this problem is
solved by a sequential simulation of the base load situation first, followed by the peak load situation. During the
- 10 -
different base load situations, the pumping storage units are considered as dispatchable loads in the OPF.
Depending on the price, a certain amount of electricity is stored in the reservoir. The assumed size of the
reservoir results from the assumption that every unit is able to generate with maximum power during all peak
load hours. According to the previous section, 30% of the time, 7.2 hours per day respectively, is considered as
peak load situation. Therefore, the reservoir has to be filled completely during the 16.8 base load hours. As a
dispatchable load is modelled with negative values in the OPF calculation, this results in the following two
constraints.

,max
,
0
i
g base
P = (6)

,
,min
,
7.2
16.8
g inst
i
g base
g
P
h
P
h q
= (7)
with the installed generating capacity
, g inst
P and the total process efficiency
g
q . The maximum price for
storing electricity is also linked with the efficiency as the expected profit during peak load hours has to cover the
expenses for the pumped energy. The expected profit is calculated on the basis of the mean of the peak prices of
the previously simulated year. For the first year an assumption has to be set. If the resulting price at node i
where unit g

is installed is below the value ( )
base
g
p t in the base load situation, then electricity is stored in the
reservoir. For the calculation of the value also the cost for operation and maintenance are considered.
( ) ( 1) O&M
base
peak
i i g
p t p t q = + (8)
In the subsequent simulation of the peak load situation, the maximum generating capacity
,max
,
i
g peak
P is set
according to the stored energy; the minimum capacity is set to zero.

,min
,
0
i
g peak
P = (9)

,max
,
( )
7.2
g
i lw lw mw mw hw hw
g peak
P l dur l dur l dur
h
q
= + + (10)
where ,
lw mw
l l , and
hw
l represent the dispatch of the pumping storage unit during base load, multiplied with
the respective duration of each wind situation.
The price or marginal cost of the unit results from the weighted sum of the stored energy
( )
( )
, , ,
( ) ( ) ( ) ( ) ( ) ( )
( ) O&M
( ) ( ) ( )
base lw lw lw base mw mw mw base lw hw hw
peak i i i
i
lw lw mw mw hw hw
g
p t l t dur p t l t dur p t l t dur
p t
l t dur l t dur l t dur q
+ +
= +
+ +
(11)
2.2.5 FACTS Devices modelling
The development of flexible controllers of transmission systems based on the progress carried out in power
electronics is essential to efficiently utilize the existing grid and generation infrastructure. Flexible Alternating
- 11 -
Current Transmission System (FACTS) devices have been largely investigated during the last decades [18]. The
impacts of these power electronic-based controllers on the power systems are well established; numerous
investigations have analyzed FACTS on congestion management, as well as their ability to improve
controllability and the security of interconnected systems [13], [18]. These are key features in a competitive
environment, where the fast-reacting FACTS controllers can properly help to avoid or relieve bottlenecks,
delaying the execution of large transmission line investment projects.
As mentioned, maybe the outstanding feature, still barely explored, that FACTS devices offer to manage
network investments under uncertainty is a set of options that enhance the transmission investment flexibility.
Those options, such as: relocation, abandonment, operational flexibility, expansion and contraction, offer a
substantial additional value to these investments and consequently, must be fairly evaluated.
Within this research, the Thyristors Controlled Series Compensator (TCSC) is analyzed under steady state
operation. This FACTS was chosen since it is most appropriate for controlling power flows in the new power
markets. In comparison to more conventional compensation strategies (e.g. fixed series compensation), it has the
advantage of a very fast output reaction to changes in control values. In fact, given that this work tries to analyze
the electric system operation under uncertainty; a continuous and flexible compensation according to the
unfolding of the uncertain variables is preferred rather than fixed and discrete series compensation [11].
The mathematical model of this device modifies the reactance of the transmission line, allowing the TCSC to
operate as capacitive or inductive compensation respectively (Fig. 3 a). The rating of TCSC is defined by the
reactance and current capacity of the transmission link where the TCSC is installed:

1
;
ij TCSC TCSC Line
Line TCSC
b X r X
X X
= =

(12)
where
Line
X is the reactance of the transmission line and
TCSC
r is the coefficient which represents the degree
of compensation by TCSC.
For static implementations, FACTS devices can be modelled by power injection models (PIM) . The PIM
model depicts FACTS as devices that inject a certain amount of active and reactive power into its nodal
connections; so that this controller operation is replicated by this injection flows. The advantages of the PIM are
that it does not lose the symmetrical structure of the admittance matrix and allows efficient and convenient
integration of FACTS devices into existing power system analytical tools [19].
On the basis of a DC power flow model, the active power flow along the line i-j with a TCSC can be
formulated as:
- 12 -
( )
ij ij i j
P b 0 0 = (13)
Therefore, the equivalent circuit of the general PIM of a TCSC under the DC approach is shown in Fig. 3(b),
in which the operation of the FACTS device is represented by two power injections on both sides of the
transmission line. These power injections are the followings:

(a) (b)
Fig. 3. (a) Equivalent circuit of TCSC, and (b) power injection model of TCSC.


, ,
( )
( )
TCSC
F i F j i j
ij ij TCSC
X
P P
X X X
u u = =

(14)
These power injections must be added to the nodal power balance constraints into the classic DC-OPF
problem (eq. (1)). Moreover, the line transfer capacity, where the TCSC is installed, may increase (10-12%) due
to the stability improvement [20]. Therefore, the constraints related to the power transfer limit in the
compensated branch must be also modified. Then, the improved transfer limit is equal to the algebraic sum of the
power and the power injection.
Due to the TCSC power injections are a function of voltage angles as well, which are state variables in DC-
OPF linear programming, there are no fixed limits for these power injections (although there are fixed limits for
XTCSC). Therefore, its operating constraints can be formulated with two additional inequality constraints, which
have to be added to the DC-OPF problem (eq. (1))

max min
, ,
max min
0; 0
( ) ( )
TCSC TCSC
F i F i
ij ij TCSC ij ij TCSC
X X
P P
X X X X X X
_ _

(15)
To avoid overcompensation, the working range of the TCSC is chosen between 0.7
Line
X and 0.2
Line
X
[21]. The DC-OPF estimates the optimal power flow injections of TCSC devices in order to minimize the
production costs. From these values, the optimal compensation level can be obtained so that:

2 *
,
*
* * *
,
( )
ij F i
TCSC
i j ij F i
X P
X
X P 0 0

=

(16)
3 Financial Evaluation
- 13 -
3.1 Decision Making of Investment Portfolios in Transmission System
By means of the Monte Carlo simulation, the cost savings (CS) for each realization along the investment
horizon are estimated. Thus, the stochastic project cash flow is defined by these cash flows and the capital
expenditures of the expansion project. Fig. 4 illustrates the resulting cash flow of a Monte Carlo realization,
which is composed by the annual
,
s
i
CS
.
, investments costs (
,
n
s t
I ) and operation cost (
,
n
s t
OC ).

Fig.4. Resulting Cash Flow for the transmission investment.

The cash flow, thus originated, is discounted by the financial cost of the investment () in order to obtain the
present value of the Incremental Social Welfare (ISW), according to the following expressions:

( )
,
, ,
;
(1 )
n
n
s
M
i
s t i
i t
CS
PV ISW
.
.
j
=
1

( )
_
(17)

( )
, , ,
, ,
;
(1 )
n
n
s
M
i s i s i
s t i
i t
CS I OC
NPV ISW
.
.
j
=
1

( )
_
(18)

( ) ( )
, , , ,
1
1

s t s t
n n
E NPV ISW NPV ISW
. .
.
\
=
l 1

l =

l
( ) \
l
_
(19)
where
,
s
i
CS
.
and
, s i
I are the generation cost savings and the investment cost respectively in the realization,
( )
,
j
s k
PV ISW and
( )
,
j
s k
NPV ISW are the Present Value (PV) and Net Present Value (NPV) of the ISW by
executing the investment strategy s in the year
n
t and M the investment horizon, finally, ( )
, ,
n
s t
E NPV ISW
.
l
l
l
l

is its expected value for Monte Carlo samples. In each case, the subscripts correspond to the h-th hour, i-th
year, -th realization of the Monte Carlo power system simulation.
If the decision was made under the traditional NPV approach, the decision making rule would dictate: When
the NPV is positive, the investment should be executed [22]. Nevertheless, this decision rule often overlooks
some implicit assumptions. Most important, it is assumed that the investment decision are of kind now-or-never
when the investment is irreversible, that is, the only decisions which the investor could make are either execute
the investment or discard the project. Although some investments meet these conditions, most do not. Nowadays,
irreversibility and the chance of postponing are quite relevant characteristics of most investments. In fact, the
- 14 -
ability to delay irreversible investment expenditure can deeply impact on the decision to invest [22]. These
features often undermine the simple NPV rule, and thus the theoretical foundation of the standard neoclassical
investment models.
The basic theory of irreversible investment under uncertainty, developed in [22], [23], emphasizes the option-
like features of the investment opportunities and proposes to develop decision rules based on methods for pricing
option in financial. Thus, to stress the analogy with the financial options, the opportunities to take investment
decisions are called real options. Besides the deferral option, there are many contingent claims (e.g. abandon,
expansion, relocation, etc.), which act as a hedge of the investments in case unfavourable market conditions
should turn out to be worse than anticipated. These options enhance the flexibility of investments, and represent
an opportunity cost that must be included as part of the investment. This opportunity cost of investing can be
large and highly sensitive to the uncertainties over the future value of the project, and investment rules that
ignore it can lead to gross errors. Within the transmission network, investments are not normally able to be
undone and the expenditures recovered. Therefore, it is somehow necessary to redefine the NPV decision rule by
including the opportunity cost of the flexibility options.
3.2 Valuing Flexible Investment Portfolios in Transmission System
Flexibility can be defined as the attribute that allows investment project adapt itself when external changes
occur. Real option (RO) is a novel investment valuation technique for valuing it, which applies concepts derived
from finance theory to the valuation of capital investments. It refers to choices on whether and how to proceed
with investment projects. In the first RO applications, valuations were normally bounded to options for which
appraisal of the financial could directly be applied. Afterwards, the introduction of multiple interacting options
into the RO models increases the problem complexity, making these traditional numerical approaches
impracticable.
In the recent years, simulation procedures for solving multiple American options have been successfully
proposed. One of the most promising approaches is the Least Square Monte Carlo (LSM) method proposed by
Longstaff and Schwartz [12]. The LSM approach is based on a Monte Carlo simulation algorithm to value the
financial American options. More recently, Gamba [24] presented an extension of this approach for valuing a
wide set of investment problems with many embedded ROs taking into account the interaction and strategic
interdependence among the options. Given an American option, with a state variable X
t
, payoff ( )
, X
t
t H that
can be exercised from
0
t until T, its valuation function can be expressed as follows :
- 15 -
( )
( )
*
( , ) max , (1 )
t
t
T
F t X X
t
t t
t
t j

' ' l 1 1
1 1
l = H
! !
l 1 1
l 1 1 + +
(20)
where t is the optimal stopping time ( [ , ]) t T t

and the operator
*
t
[.] represents the risk neutral expectation
conditional on the information available at
n
t , which could also be expressed by
*
t

l

l
. The discount factor
between any two periods is
1
(1 ) df j

= .
Under this approach, the underlying asset evolution is simulated through a Monte Carlo simulation. Then, the
optimal stopping policy for each simulated path is obtained using Bellmans principle of optimality: An optimal
policy has the property that, whatever the initial action, the remaining choices constitute an optimal policy with
respect to the sub-problem starting at the state that results from the initial action [22]. This means, it is possible
to split the decision sequence into two parts, the immediate period and the whole continuation beyond that:

( ) ( )
1
*
1
( , ) max , , ,
n n n n
n t n t t n t
F t X t X F t X df

' ' l 1 1
1 1
= H l ! !
1 1 l
l 1 1 + +
(21)
At this point the LSM makes its key contribution. This approach proposes to compute the continuation for all
previous time-stages by regressing from the discounted future option values on a linear combination of
functional forms of current state variables [25]. Working recursively until
0
0 t = , the optimal decision policy
on each path choosing the largest between the immediate exercise and the expected continuation value can be
computed. Finally, by applying the following equation the American option value is calculated.

( )
( )
( )
1
1
(0) ( ), ( ) F X df
t .
t .
.
t .
\

=
= H
\
_
(22)
As pointed out in [11], traditional investment appraisal methods are typically inappropriate when assessing
transmission investments, since the presence of uncertainties dramatically increases the risk involved in
irreversible large-scale decisions. Moreover, these investments have embedded multiple flexible options which
are difficult to assess but significantly impact on the optimal decision making.
It has been considered as investment alternatives: 1. a FACTS device and 2. a transmission line (TL).
Therefore, the available investments strategies are either investing in the FACTS first, in the line first or jointly
in the FACTS and the line. The strategic flexibility of postponing both investments as well as abandoning or
relocating the FACTS device are compounded options. Hence, these available options are valued by means of
the LSM method, by applying the following Bellmans equations [11]:
1. Option to invest first in the FACTS:
( ) ( ) ( ) ( )
( )
1 1 1
1
1 1 1
*
1
, max , ; , ; , ;
( , ) max
,
n n n n
n
n n
F
F n t R n t A n t TL n t
F n t
t F n t
t X F t X F t X F t X df
F t X
F t X df

' ' 1 1 1
1 1
H

1 1

( ) 1 1 1 1
=
! !
l
1 1
1 1 l
1 1
l 1 1
l 1 1 + +

(23)
- 16 -
2. Option to invest first in the line:

( ) ( )
1 1
*
1 1
( , ) max , ( , ) ; ,
n n n n n
TL
TL n t TL n t F n t t TL n t
F t X t X F t X df F t X df


' ' l 1 1
1 1
= H l ! !
1 1 l
l 1 1 + +
(24)
3. Option to invest in the FACTS and the line jointly:

( ) ( )
( )
1 1
1
& &
& 1 1
&
*
& 1
, max ( , ); ( , ) ;
( , ) max
,
n n n
n
n n
TL F TL F
TL F n t R n t A n t
TL F n t
t TL F n t
t X F t X F t X df
F t X
F t X df

' '
1 1
1 1 H
1 1
1 1
=
! !
l
1 1
1 1 l
1 1
l
1 1 l + +

(25)
where ( , )
n
n
m n t
F t X is the option value and ( , )
n
n
m n t
t X H the profit value, both for the option m (F: FACTS, L:
transmission line, R: FACTS relocation, A: FACTS abandon) at the state n (F: FACTS investment done, L: line
investment done, Ab: FACTS abandon done. Expanding the equation (23):

( ) ( )
( )
1
1
1
*
1
, max ( , ); ( , ) ;
( , ) max
,
n n n
n
n n
R
R n t TL n t A n t
R n t
t R n t
t X F t X F t X df
F t X
F t X df

' '
1 1
1 1 H
1 1
1 1
=
! !
l
1 1
1 1 l
1 1
l
1 1 l + +

(26)

( ) ( )
1
*
1
( , ) max , ( , ); ,
n n n n n
A
A n t A n t TL n t t A n t
F t X t X F t X F t X df

' ' l 1 1
1 1
= H l ! !
1 1 l
l 1 1 + +
(27)

( ) ( )
( )
1 1
1
& &
1 1
*
1
, max ( , ); ( , ) ;
( , ) max
,
n n n
n
n n
F TL F TL F
TL n t R n t Ab n t
F
TL n t
F
t TL n t
t X F t X F t X df
F t X
F t X df

' '
1 1
1 1 H
1 1
1 1
=
! !
l
1 1
1 1 l
1 1
l
1 1 l + +

(28)
In the same way, developing the equations (24) and (25):

( ) ( ) ( )
( )
1 1
1
& &
1 1
*
, max , ; , ;
( , ) max
,
n n n
n
n n
TL TL F TL F
F n t R n t Ab n t
TL
F n t
TL
t F n t
t X F t X F t X df
F t X
F t X df

' ' 1 1 1
1 1
H

1 1

( ) 1 1 1 1
=
! !
l
1 1
1 1 l
1 1
l 1 1
l 1 1 + +

(29)
( ) ( ) ( )
1 1
& , & & * &
1 1
( , ) max , , ; ,
n n n n n
TL F R TL F TL F TL F
R n t R n t Ab n t t R n t
F t X t X F t X df F t X df


' ' l 1 1
1 1
= H l ! !
1 1 l
l 1 1 + +
(30)

( ) ( )
1 1
& & * &
1
( , ) max , ; ,
n n n n
TL F TL F TL F
Ab n t Ab n t t Ab n t
F t X t X F t X df

' ' l 1 1
1 1
= H l ! !
1 1 l
l 1 1 + +
(31)
In the investment cases:

( )
( )
, ,
, ,
, ( )
n n
n
n
m n t s t
s t
t X PV ISW I
.
.
. H = (32)
where
, ,
n
s t
I
.
is the investment cost of the s-th investment strategy at the
n
t -th year. On the other hand, in the
relocation and abandon cases:

( ) ( )
, , ,
, ( )
n n n
n
R n t R t t
t X PV ISW CR
. .
. H = (33)
- 17 -

( )
( )
,
, ,
, ( )
n n
n
n
A n t t
s t
t X SV PV ISW
.
.
. H = (34)
where
,
n
t
CR
.
is the relocation cost and
,
n
t
SV
.
is the scrap value of the FACTS devices at the
n
t -th year.
The present values, expressed in equations (32) to (34), are calculated according to equation (17) and
regarded as underlying assets for the RO valuation. Based on each available investment strategy, the resulting
cash flow is composed. An illustrative example is shown in Figure 5, where one strategy, invest first in the
FACTS, one year later in the line and finally during the third year abandon the FACTS device, is exposed. In all
cases, the investment project begins to operate one year after the investment execution. It is important to notice
that all possible investment strategies and their intrinsic real options have been exhaustively evaluated, that is all
possible combinations among the available flexibility options are assessed.
By applying this procedure, the option values for each strategy are calculated. Hence, the optimal investment
strategy is the one with the highest value. It is important to notice that the optimal decision policy obtained by
the LSM approach is not a deterministic value. Actually, there is an optimal policy for each simulated path.
Therefore, it is possible to determine a probability density function of option values.

Fig.5. Cash flow composition for a transmission investment strategy.

Accuracy of the estimates of the value of the option values can be improved by increasing the number of time
steps N, the number of simulated path . Hence, the Monte Carlo stop criterion applied is the control of the
relative error [26]. Setting 10% c = entails demanding a confidence level in the attributes assessment of 95%.

1
(0)
(0)
1
2
(0),
(0)
m
n
m
n
F
m
s n
F m
n
F
F
c
c o
o

1 ( )

=

( )
\
(35)
- 18 -
where
1
c

is the inverse of the Standard Normal Distribution (SND), ( ) 1 / 2 c the confidence level specified,
( )
1
1 / 2 c c

critical value of a SND with mean 0 and standard deviation 1 and

(0)
m
n
F
o the volatility of the
expected option value. Within this work, it is assumed as maximum relative error 1%.
4 Study case: simulations and results
4.1 Calculation of the investment option values
Based on the framework exposed in the previous sections, the impact of two network upgrades on the OMG
cost is analyzed. These upgrades are the development of a new 380-kV-double-circuit and the installation of a
FACTS device. Both upgrades represent measures to strengthen the German-Dutch interconnections due to the
facts that these are one of the most important corridors within the Central Western European (CWE) region.
Hence, an interconnection project, which is currently under study, is compared to flexible investment in order to
analyse the influence of the strategic flexibility on the optimal decision making process. The upgrades have the
following features:
- Upgrade 1: Development of a new 380-kV-double-circuit on a length of 85 km. between nodes 14 and
48, leading to investment costs of about 59.5 M and annual operating costs of about 0.595
M/year.
- Upgrade 2: Installation of a TCSC device of -130/40 MVar between nodes 8 and 40, with the option to
relocated it between the nodes 20 and 45, leading to investment costs of about 30.8 M and annual
operating costs of about 0.308 M/year [20]. In addition, the scrap value of the FACTS device and
its relocation cost are considered equal to 40% and 20% of the total capital cost I respectively.
Therefore, there are three mutually exclusive options (strategies), which are evaluated:
- investing in the FACTS device first (S
1
),
- investing in the transmission line first (S
2
) or,
- investing in the FACTS and line jointly (S
3
).
It is considered as maturity for all investments options three years and 15 years as the investment horizon.
Lead construction time is assumed to be one year and discount rate is set to 8% p.a. for all considered
- 19 -
transmission projects. The network and data described in the previous sections is applied in 1000 calculations of
the Monte Carlo simulations for ensuring the maximum relative error established in the last section. Hence,
several
4
OPF calculations are performed for each scenario (base and investment). By this means, the stochastic
annual generation cost savings are estimated. Fig. 6 shows the evolution of the relative error as well as the
stabilization of the option value estimation.

(a) (b)
Fig.6. (a) Relative error of option values of each alternative, and (b) statistical stabilization of the option values estimation.

The results of the investment evaluations are depicted in Table V. The traditional NPV appraisal suggests S
3

as the optimal investment choice. Conversely, the RO valuation determines S
1
as the optimal decision by taking
into account the strategic flexibility provided on each strategy. Since the option value can be calculated
according to (22), the economic value of the flexibility of each investment strategy is given by the difference
between the option value and the expected NPV value.
TABLE V
RANKING OF STRATEGIES BY APPLYING THE PROPOSED EVALUATION APPROACH AND THE TRADITIONAL APPRAISAL.
Strategy
Expected Option Value (M) Expected NPV value (M) Flexibility (M)
S
1
278.870 (1
st
) 46.227 (3
rd
) 232.643 (1
st
)
S
2
194.699 (3
rd
) 108.826 (2
nd
) 85.873 (3
rd
)
S
3
229.866 (2
nd
)

141.368 (1
st
) 88.498 (2
nd
)

4
108.000 OPFs were conducted per investment strategy (2 load scenarios x 3 wind scenarios x 17 years x 1000 simulations). 17 years were
simulated in order to consider the 15 years and the maturity of the options, three years.
- 20 -
Both the probability density function (PDF) as well as the cumulative distribution functions (CDF) are shown
in Fig. 7. It can be seen that which a probability larger than 95 %, the option value of the strategies S
1,
S
2
,S
3
are
about 193 M, 121 M and 152 M respectively. Therefore, the optimal flexible investment strategy though
the traditional investment appraisal (NPV) indicates S
2
as the optimal investment alternative is to invest first in
FACTS devices. The strategic flexibility of FACTS remains after the investment has been executed allowing a
better adaption to adverse scenarios that can take place in the long-term.

(a) (b)
Fig. 7. (a) Cumulative distribution function (CDF), and (b) probability density function (PDF) of the analyzed strategies.

Table VI portrays the relative frequency of the optimal investment policy for S
1
. It can be noted that there is a
slight trend to exercise the investment option in year 1. This means to postpone the investments for one year.
Nevertheless, the number of scenarios to install the FACTS immediately is quite significant. It is also important
to highlight that the investment is executed under any scenario in one of the first two years. In addition, the
optimal execution strategy of the sequential option generated by the FACTS investment is exposed in Table VI.
As is shown, the options of relocation and line investment (once installed the FACTS) are most likely executed
at their maturity dates.
In the analytical RO approach, the most important preposition is the positive correlation between the value of
an investment opportunity and the volatility of the underlying asset.

- 21 -
TABLE VI
RELATIVE FREQUENCY OF THE OPTIMAL INVESTMENT DECISION AND RELATIVE FREQUENCY OF THE OPTIMAL EXECUTION OF THE GENERATED
OPTION BY THE FACTS INVESTMENT.
Option Never Year 0 Year 1 Year 2
To invest in FACTS first 0% 43.1% 56.9% 0%
To invest in the Line once the FACTS investment have been done 0.1% - 1.7% 98.2%
To relocate the FACTS once the investment have been done 0% - 0.2% 99.8%
To abandon the FACTS once the investment have been done 100% - 0% 0%

In the analytical RO approach, the most important preposition is the positive correlation between the value of
an investment opportunity and the volatility of the underlying asset. For proving this relationships into the
proposed simulative approach, the volatilities of the demand growth as well as of the fuel prices are in three
different levels: 1. completely deterministic, volatilities equal to zero; 2. the volatilities used in the calculations
made before; and, 3. the volatilities are doubled compared to the aforementioned scenario. For these three levels,
the simulations are carried out and the option values for each investment strategy are estimated. As exposed in
Table VII, this tendency is held. The option value increases in all cases when the volatility increases. This also
shows that the investment portfolio with FACTS is the most improved. This attribute is highly desirable
regarding the ongoing growth of the uncertainties in the deregulated power markets.
TABLE VII
OPTION VALUE AND VOLATILITIES.
Strategy
(M)
Volatility Level
0% 100% 200%
S
1
225.7 278.9 283.7
S
2
154.1 194.7 202.4
S
3
177.7 229.9

230.1

4.2 Impact of the network upgrades
In order to analyse the impact of the different possible network upgrades from a technical point of view, at
first the total generation in the Netherlands is extracted from the OPF calculations. The generation in the
Netherlands provides a hint regarding the utilization of the transmission network because the Netherlands can
only import electricity from Germany and Belgium. Due to the power plant mix with only a few low-cost power
plants, NL imports electricity nearly all the time.
Table VIII summarizes the mean values of the relative loading of the cross-border line connecting the
Netherlands with Germany and Belgium in the year 2. This year is the first possible point with one of the
network upgrades in operation. After the decision in year 0, one year for the construction is assumed, leading to
possible operation in year 2. It can be observed that the load/wind situation shows a higher influence on the line
- 22 -
loading than the different network upgrades. The interconnections in all cases, even in the base case, are
operating below its capacity rates, mainly because of the appearance of congestions in another interconnection
line, which bound the cross border flow from the German wind generation to Netherland. Here it should be noted
that the only investment strategy which increases the power import of Netherland is the case of the FACTS
investment. This could be interpreted as the FACTS controller is able to take the maximum advantage of the
existing interconnected capacity, by operating the existing grid infrastructure more efficiently.
Fig. 8 summarizes the resulting generation for the six regarded load/wind situations as well as the different
network upgrades. Obviously, the main driver is the load level but also the actual wind generation in Germany
considerably influences the generation in the Netherlands. The high fluctuation margin within the 1000 trials for
each situation is quite remarkable already for the depicted year 2.
TABLE VIII
MEAN VALUES OF THE LOADING OF ALL CROSS-BORDER LINES CONNECTING THE NETHERLANDS (YEAR 2)
Investment
Scenario
Base Peak
hw mw lw hw mw lw
base case 40.8% 29.3% 27.2% 44.7% 39.4% 33.9%
FACTS 42.2% 30.3% 27.8% 45.8% 40.5% 34.7%
FACTS relocated 40.5% 30.2% 28.0% 39.0% 39.2% 34.4%
line 34.3% 24.2% 22.6% 37.0% 32.5% 27.5%
FACTS & line 34.1% 24.9% 22.9% 37.7% 33.0% 28.0%
FACTS rel. & line 29.1% 22.8% 22.2% 31.2% 30.4% 27.5%

0
2000
4000
6000
8000
10000
12000
14000
hw mw lw hw mw lw hw mw lw hw mw lw hw mw lw hw mw lw hw mw lw hw mw lw hw mw lw hw mw lw hw mw lw hw mw lw
base peak base peak base peak base peak base peak base peak
base case FACTS FACTS relocated line FACTS & line FACTS rel. & line
P
gen
(MW)
min
max
mean

Fig. 8. Fluctuation margin of the total generation in the Netherlands, depending on the network upgrades for all regarded load
and wind situations (year 2).

Despite the fluctuations within one load/wind situation, there is no clear trend coming from the network
upgrades. Even though the total cross-border capacity between the Netherlands and Germany is increased by any
of the upgrades, the import into NL and the respective total generation does not change significantly. Neither the
mean values nor the fluctuation margins are influenced in a clear direction. This highlights on the one hand the
- 23 -
complexity even of this reduced sample of the actual power system. On the other hand, these observations clarify
the necessity of considering quite a high number of different situations and stochastic influences in order to
evaluate especially long-term impacts on the power system.
5 Conclusions
In this paper, the application of a new framework for assessing flexible investments in the European
interconnected transmission network under uncertainties has been presented. The focus is on the economic
valuation of the options of relocation and abandon of FACTS. The main uncertain variables which define the
transmission operation performance have been modelled and properly managed by selecting flexible expansion
projects aiming at improving the investment risk profiles. It was revealed that traditional investment appraisal
methods may be unsuitable for valuing flexible transmission investments, since the presence of uncertainties
considerably increases the value of the flexibility embedded in the decision making process. Flexibility of
postponing, relocating or abandoning an investment in the light of unfolding information has been quantified.
In a study case, it has been shown that by properly combining FACTS devices and traditional investments in
transmission lines along the investment horizon, more flexible investment strategies can be obtained and the
adaptability to uncertain future scenarios are improved. Furthermore, it has been illustrated how the optimal
decision could be misled under the traditional NPV rule. By applying the RO approach an important feature of
FACTS was highlighted: inducing the investment execution in stages by the means of deferring large
transmission line projects. The impact of the fluctuating feed-in from renewable energies and the operation of
pumped storage plant has also been analyzed. The large impact of the generation pattern within the different
countries on the cross-border power flows was pointed out. Obviously, all these aspects have a straightforward
influence on the decision to upgrade interconnections.
Future research should be focused on a detailed assessment of the impact of different scenarios of wind
power in-feed as well as uncertainty of the installed wind capacity on the decision making process. The
presented approach might also serve as a basis for a decision making tool for regulatory agencies in order to
quantify the necessity for network upgrades.
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