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Substantial R &D efforts are currently directed towards the development of combined heat and power (CHP) systems that automatically and seamlessly connect to the power grid. In this paper we develop a real options model to assess the impact that the operational flexibility characterizing such systems will have on the optimal timing and capacity associated with investments in CHP plants. We take the viewpoint of a manufacturer operating in an energy-intensive industry who contemplates investing in CHP. We discuss and compare investments in two types of CHP systems: a standard one that is operationally rigid and a technologically advanced one that is operationally flexible. The interaction between temporal and operational flexibility under uncertainty and irreversibility is central to our analysis. We show that operational flexibility guarantees earlier investment but has an ambiguous effect in terms of capacity. In particular, when operational flexibility is very valuable the potential investor is opting for investing in a plant with larger productive capacity. The potential investor chooses a smaller CHP unit if otherwise. A numerical exercise calibrated using data from the Italian pulp and paper and electricity industries complements our theoretical analysis.

We examine the case of a firm holding the option to make an uncertain and irreversible investment. The firm is decentralized and there is information asymmetry between the owner and the investment manager regarding the price of an input (e.g. a key equipment) that needs to be purchased by an outside supplier with market power. We show that the total loss attributed to the information asymmetry has two components: i) the loss in the decentralized firm itself and ii) a negative externality that the outside input supplier endures. We show that the latter is not just a part, but likely the main component of the total loss. Last, we prove that the negative externality is reduced when the principal uses an audit technology in parallel with the bonus-incentive mechanism.

We find the optimal time for exercising a jointly held investment option. When the input market is competitive, the investment can take place earlier, later, or exactly when the optimal investment threshold is reached depending on how the option holders interact and on the bargaining power distribution. When instead the input supplier has market power, the game-theoretic framework downstream is shown to be of secondary importance. The timing effect that is attributed to the vertical relationship is always prevailing, which dictates the inefficient postponement of the investment.

We develop a real options model to assess the impact of decoupled payments on agricultural investments. The context that we are addressing is the one set by the Common Agricultural Policy where farmers are eligible for decoupled payments as long as their land is properly maintained. We show that decoupled payments are non-neutral with respect to choices concerning timing and capacity. We find that they (i) induce earlier investment with lower productive capacity; (ii) increase the value of the investment option associated with land and (iii) reduce the volatility of farm income. A numerical exercise complements our theoretical analysis.

We study how overlapping ownership affects investments in a preemption race with market uncertainty. Internalization of rival payoffs delays follower entry if product market effects are moderate, implying longer incumbency which intensifies the race to lead. Preemptive and follower investment thresholds increase with volatility as in standard real option models but firm value can decrease, and greater volatility makes internalization more profitable. From a welfare perspective there is a tradeoff between a dynamic benefit and a static cost of overlapping ownership. Whereas it is socially optimal not to have any overlapping ownership in some markets, at low volatility levels we find firms have an insufficient incentive to internalize.

Billette de Villemeur et al. [Billette de Villemeur, E., Ruble, R. and Versaevel, B. [2014] Investment timing and vertical relationships, Int. J. Industrial Organization 33, 110–123] discuss the case of a firm undertaking a project in order to serve an uncertain demand. They show that when the investor requires an outside supplier with market power to provide it with a discrete input the investment occurs too late from an industry stand point. In this paper, we extend their work assuming that the input production cost is also uncertain. We show that upstream market power results in dynamic inefficiency also in our framework. We also demonstrate how this inefficiency is affected by the correlation between the two stochastic terms.

We study the optimal design of Public-Private Partnerships (PPPs) when there is unobservable action on the private party's side. We show that if the private party does not have negotiating power over the project's surplus, then no inefficient delays are attributable to the moral hazard issue. However, if the private party has negotiating power, then the first-best timing is not guaranteed. The time discrepancy is shown to be costly in terms of overall project efficiency. The explicit consideration of the private party's negotiating power can explain empirical evidence that private parties in PPPs tend to reap excess returns. These results are discussed in light of the COVID-19 pandemic and its implications for PPPs.

We study how overlapping ownership affects investments in a preemption race with market uncertainty. Internalization of rival payoffs delays follower entry if product market effects are moderate, implying longer incumbency which intensifies dynamic competition. Preemptive and follower investment thresholds increase with volatility as in standard real option models whereas firm value can decrease, and greater volatility makes internalization more profitable. From a welfare perspective there is a tradeoff between dynamic benefit and static costs of overlapping ownership. Whereas it is socially optimal not to have any overlapping ownership in some markets, at low volatility levels we find firms have an insufficient incentive to internalize.

Reliability Options (ROs) are used to enhance the security of supply in electricity systems. When a power producer writes a RO, s/he agrees to set a cap on the price of electricity that s/he cashes. In return, the system operator, i.e., the party that is buying the option, pays to the option issuer a premium unaffected by price volatilities. In this paper we analyze how ROs affect the timing and value of investments in the energy sector and we show under what conditions they can be used as investment stimuli. We prove that, contrary to what is expected, ROs can harm the security of supply by delaying the adoption of new capacity and by reducing the value of investing in it. To avoid such a result, a careful setting of the relevant parameters is needed.

Reliability Options (ROs) are used to enhance the security of supply in electricity systems. When a power producer writes a RO, s/he agrees to set a cap on the price of electricity that s/he cashes. In return, the system operator, i.e. the party that is buying the option, pays to the option issuer a fixed premium. In this paper we analyze how ROs affect the timing and value of investments in the energy sector and we show under what conditions they can be used as investment stimuli. We prove that, contrarily to what is expected, ROs can potentially harm the security of supply by delaying the adoption of new capacity and by reducing the value of investing in it. To avoid such a result, a careful setting of the relevant parameters is needed.

Under the current version of the Common Agricultural Policy (CAP), payments to EU farmers are decoupled from the production of agricultural commodities. In fact, farmers qualify for CAP support as soon as their land is maintained in good agricultural and environmental condition. In this paper, we study how decoupled payments influence the decision to invest in farming. We show that decoupling is implicitly providing a costless hedge against volatile farming profits. Consequently, a higher decoupled payment leads the potential farmer to hasten its investment but also results in a farm with lower productive capacity.

We examine the case of a firm holding the option to make an uncertain and irreversible investment. The firm is decentralized and there is information asymmetry between the owner and the investment manager regarding the price of an input (e.g. a key equipment) that needs to be purchased by an outside supplier with market power. We show that the total loss attributed to the information asymmetry has two components: i) the loss in the decentralized firm itself and ii) a negative externality that the outside input supplier endures. We show that the latter is likely not just a part, but rather the main component of the total loss. Last, we prove that the negative externality is reduced when the principal uses an audit technology in parallel with the bonus-incentive mechanism.

We find the optimal time for exercising an investment option that is jointly held by two parties. When the sunk investment cost is exogenous and the two parties act non-cooperatively the investment takes place inefficiently late whereas when a Nash bargaining constitutes a Pareto improvement the investment takes place inefficiently early. On the contrary, when the sunk investment cost is endogenous, as for instance is the case when an upstream firm is responsible for the provision of a needed input (e.g. a key equipment), we show that the game-theoretic framework downstream is of secondary importance since the timing effect related to the vertical relationship is always prevailing, dictating the inefficient postponement of the investment.