Real Options

Real options have captured the imagination of financial analysts, business planners, and cost analysts. They should also be part of every regulator’s tool kit.

What is a real option? A real option is the opportunity, but not the obligation, to make a particular decision. For example, when an electricity producer delays a decision about whether to expand an existing generating plant or invest in wind energy, it has a real option to take either path sometime in the future. A real option has value because it delays putting a stake in the ground until more uncertainty is resolved.

Why are real options important for regulators? Today’s utility environment is marked with uncertainty and ambiguity. What kinds of new broadband technologies will there be? Will broadband be regulated? Will renewable energy portfolios be mandated? How long will new energy policies last? Which innovations in energy storage, production, and use will affect utility asset values? What will happen when water prices reflect opportunity costs?

Current and upcoming conference themes illustrate this uncertainty. One conference looks at what the new U.S. president should know about broadband. Another considers what investors, utilities, regulators, politicians, and the media should know about each other and about the new president’s attitudes on energy policy. A third conference asks whether the role of utility regulation has fundamentally changed.

How should regulators apply real options theory? One way is to keep options open while new information is being gathered. A group of regulators at a recent leadership seminar called this “creating off‐ramps.” They were concerned about detailed legislation being passed without good information and knowledge about how utility services actually work. The regulators couldn’t change legislation, but they could create safety valves and could avoid creating rules that create costs and foreclose options, either for utilities or for regulators. Sometimes avoiding a decision is more valuable than making one.

Another way to apply real options theory is to engage in active learning and dialogues with stakeholders. Real options have value because they allow time for the acquisition of information and knowledge. However, time is not a teacher by itself. Proactive discussions that challenge common viewpoints, research that discloses new facts and searches for new ideas, and new experiences that broaden horizons are needed.

Applying real options in regulation is challenging because in some ways it runs counter to the basic design of regulation by utility commissions. Commissions, as we know them today, were created to provide a stable environment for investment, protect consumers against the exploitation of market power and undue discrimination, and keep politics and stakeholders at arm’s length from the workings of economic regulation. Properly applied real options theory is consistent with these goals, and may actually help accomplish them, but the real options approach will not be business as usual. It means holding back and letting markets, technology, and attitudes evolve. It also means putting work back on stakeholders and politicians to engage in their own adaptive work. This will often be an unpopular thing to do, but as Ron Heifetz and Marty Linsky said in their book, Leadership on the Line, leadership is disappointing people at a rate at which they can endure.