Strategic real options with the German electric power market in view

Abstract

This thesis examines the timing of investment and closure of firms in duopolistic markets that are subject to aggregate shocks. The real options theory propagates that under uncertainty a firm's opportunity to choose the timing of capacity expansion and reduction freely adds some value to the firm, the option value of delay, and makes this firm a real options holder. In its standard form this theory only applies to perfectly competitive markets, monopolies and myopic firm scenarios. In oligopolistic markets, however, investment and closure options affect the firms' market power and, thereby, give rise to a different value, the strategic value of (dis)investment. The impact of such value on the firms' behaviour has been extensively investigated by the theory of industrial organizations - without considering the implications of the option-like nature of investment and closure opportunities.In this thesis we propose endogenous closure timing games in duopolistic markets with stochastic demand. It is shown that equilibrium exercise policies for closure options in a symmetric duopoly could differ significantly from the closure rules suggested by the standard real options theory, i.e. the strategic value of disinvestment could either offset or enhance the effect of the option value of delay on the firm's behaviour. These results suggest that the theory of industrial organizations can strongly contribute to the real options approach - and vice versa: in the model with heterogeneous firms we provide an implicit indication for further analysis of how the option value of delay, driven by the level of demand uncertainty, could affect the number of equilibria. From the social planner's perspective we also discuss under which conditions either a loose or a restrictive approach to the assessment of mergers in declining industries would be preferable.We also review an endogenous investment timing game with two identical firms that has been proposed by Huisman and Kort (1999). By contrasting their results with the investment rules suggested by the real options theory we show that duopolists might also choose a timing of investment that is very different from the investment strategies of price-takers or monopolists. So, due to the strategic value of investment, the standard real options investment triggers do not translate to the duopolistic case in general. As with strategic closure options, a discussion of welfare and policy issues completes the analysis.Finally we present an empirical approach to assess whether the magnitude of the strategic value of disinvestment is statistically significant, and thus whether it, in addition to the option value of delay, should be taken into account by the rivals in a duopolistic market. We apply our approach to a real-world closure timing game between RWE and E.On, the main players in the German electric power market. The game began in October 2000, when both companies announced the closure of about 5000 MW excess capacity. Our results provide strong empirical evidence that the first player who switches from standard real options closure strategies to a best-response strategy against his price-taking rival raises the firm's profits considerably.