Managing Director Tomas Haug and Senior Consultant Dr. Adjmal Sirak recently published a chapter in The Palgrave Handbook of Zero Carbon Energy Systems and Energy Transitions titled “Regulation of Electricity Interconnectors in the EU: Providing Efficient Investment Incentives for Project Developers Through the Lens of the ‘Real Options’ Approach.” The authors introduce an innovative approach to regulating electricity interconnectors, which enables the continued deployment of renewable energy sources to address climate change.
Setting return caps for interconnectors exposes regulators to a whole new challenge: At what threshold level should returns be capped (or shared with network users) so that the interconnector can expect to recover its costs, including an adequate rate of return? In their chapter, the authors show the widely used Capital Asset Pricing Model alone is not suited to provide a meaningful answer to this question, as interconnectors do not serve a captured customer base like onshore Transmission System Operators (TSOs) do. Introducing a regulatory cap limits the interconnector’s upside, but leaves it with downside risk, which necessitates careful calibration of the cap. The authors show that real options analysis can set the “right” return threshold. The real options framework may also be applied to other regulated infrastructure facing demand uncertainty and limited market power.