Option Games in Water Infrastructure Investment

Abstract

This paper proposes the use of option games as a tool to evaluate trade-offs between flexibility and strategic commitment in industrial water infrastructure projects. Option games meet the challenge of balancing competitive pressure to commit to big-budget projects against a more flexible approach that keeps investment options open. This hybrid approach, which combines real options and game theory, overcomes the shortcoming of traditional investment valuation methods, such as net present value or real option analysis, which do not resolve the challenge. The option games are enumerated by combining a real-options binomial tree and a payoff matrix under conditions of two investment competitors with four strategic scenarios. The calculated results are compared with traditional net present value and real option analysis to show the final value of investment. The application methodology is illustrated through the case of Government of Thailand (GoT) investments in tap and industrial water supplies and/or the private sector (PS) in recycled-water development. The investments are evaluated under four different strategic scenarios: (1) both invest, (2) GoT invests first, PS waits, (3) PS invests but GoT waits, and (4) both wait. The paper indicates that option games provide a tool that allows decision makers to accurately value all choices with consideration not only of future uncertainties, but also of competitors’ decisions. Policy makers or managers can make rational investment decisions by quantifying the values of commitment and flexibility.