Accounting for Model, Policy and Downside Risk in the Economic Viability Assessment of Investments in Electricity Capacity: The Hurdle Rate Approach

Abstract

Simulation methods are often used in a forward-looking evaluation of a country’s security of supply of electricity. The framework includes modelling the investors’ decision to invest in new or existing capacity. A realistic model needs to account for the large variability and non-normality of the inframarginal rents. This discussion paper first presents an overview of several potential investment rules. Based on this overview, we recommend modelling the investment decision using the simulation-based expected return and hurdle rates that are set equal to the cost of capital of a reference investor plus a hurdle premium. The latter serves as an important cushion to compensate for the predicted project risk under the base scenario, and the model and policy risk related to alternative scenario outcomes. The discussion paper also presents a baseline simulation setup and a proof of concept, including a tentative calibration of the hurdle rate under this simulation setup.