Demand Volatility and Firms’ Investments in Operating Flexibility: Evidence from Planned Power Plants

Abstract

How does demand volatility affect firms’ investment decisions? We consider this issue from the perspective of electricity-producing firms. Their most important investment decisions concern their new power plants, which vary substantially in their flexibility to adjust their output to changing market conditions. Using an international sample of planned power plants, we find that more volatile demand causes firms to invest more in flexible plants and less in nonflexible plants, while the overall investment level remains unchanged. This effect, which is robust to a number of alternative specifications, including a weather-based IV for demand volatility, is consistent with models in which asset flexibility is an important attribute of investments when demand is volatile.

Keywords: Demand volatility, firm investment, operating flexibility, operating leverage, power plants

JEL Classification: G30, G31