Regulation and Investment under Uncertainty: An Application to Power Grid Interconnection

Using real options, we consider a firm that must undergo a costly and time-consuming regulatory process before making an irreversible, lagged investment whose value varies randomly. We apply our model to Hydro-Québec's proposal to build a 1,250 megawatts interconnection with Ontario. We find that the optimal starts of the regulatory review and of the project construction depend on the randomness of project benefits and on the duration of the regulatory authorization. A sensible limit on the latter allows the regulator to address changing circumstances at little cost to the firm. However, long and uncertain regulatory proceedings make investing less attractive.