Investment decisions in generation assets: A portfolio theory approach

Generation companies operating in a competitive market face price and volume risks that affect their return. Being able to identify and quantify these risks for each type of generation asset and how they interact is fundamental when making investment decisions regarding the portfolio of generation assets. This paper proposes a set of tools to support the decision of investment in a portfolio of generation assets, according to portfolio theory. The concept of efficient frontier of risk and return as set in that theory is used to find optimal generation portfolios. Gas-, coal- and fuel- fired as well as hydroelectric and on shore wind power plants are considered. Risk and return are estimated through Monte Carlo simulation of free cash flows. For that effect, exogenous variables such as fuel, electricity and emission prices, wind speeds and water inflows are modeled with stochastic processes. Investment decisions are studied for two perspectives: fixed capital costs allocation and installed capacity allocation. Considering constraints for risk, return and capacity over the efficient Pareto frontier, decisions of buy and/or sell required to achieve optimal generation portfolios are pointed out.