Investment, firm value, and risk for a system operator

With the liberalization of energy markets integrated energy companies have separated into entities that specialize in production and/or transmission of energy. Transmission of energy requires balancing the grid to guarantee system security, which is performed by the (independent) system operator (SO). When the SO faces stochastic demand, grid balancing has sizeable consequences on current and future profits, and hence, on firm value and firm risk. We explore these value and risk consequences with and without an investment option to expand transmission capacity. We show that firm value consists of the value of the transmission capacity in place plus the value of a short put and a short call option that are the result of the SO's balancing actions. Firm risk without investment option is non-linear and determined by the short option positions. It is decreasing with increasing energy demand. The existence of an option to expand transmission capacity increases firm value and firm risk.