The Value of Flexibility to Switch between Water Supply Sources. Applied Mathematical Sciences, Vol. 6, 2012, no. 128, 6381 – 6401.
Abstract:
Technological innovations lead to the construction of water utilities characterized by a high operational flexibility and high irreversible sunk costs. It is quite common today to design integrated aqueduct systems (namely vertical integrated systems with several interconnections between the network infrastructures). The interconnection and integration between supply sources, in fact, enables the system to handle crisis in the provision of the service caused, for example, by pollution emergencies or peaks in day demand curves. We argue that this operational and technical flexibility has an economic value which might turn out to be economically relevant in terms of the provider’s profits if optimally exercised. The interconnection of water abstraction plants, in fact, gives, de facto, the provider the option to strategically decide the optimal switching rule between two different water sources in order to maximise its profits. According to the real option theory, we develop an investment decision model under uncertainty which takes into account the value of the flexibility to switch and we show that interconnection between water sources, though it costly and involves high irreversible sunk costs, may be more profitable than investing in a single-source water abstract plant.
