Real Option Valuation of Flexibility in Operation and Maintenance Contracts of Water Pipelines Based on Reliability Analysis

Abstract

Pitting corrosion of buried cast iron water pipelines causes damage that cannot be easily detected without advanced monitoring tools. Structural reliability analysis can be used to account for the inherent environmental and mechanical uncertainties of these infrastructures and accurate prediction of their life-cycle performance. In this study, the probabilistic performance of corrosion-affected water pipeline, in terms of the extent of damage, is forecasted using a reliability-based power law model. This performance indicator follows a lognormal process that in turn can be modeled as the underlying geometric Brownian motion with drift for the valuation of maximum expense limit and minimum revenue guarantee clauses of an operation & maintenance (O&M) contract. Binomial trees have been constructed to evaluate the corresponding American real options. This quantitative performance indicator can be used instead of condition state to determine subjectively and qualitatively the severity and extent of damage. Therefore, the merit of this novel integrated analysis is that the valuation of contractual flexibilities is based on accurate reliability-based analysis. It is hoped that the proposed methodology sheds new light onto the development of advanced asset management systems that enable O&M contractual parties a risk-informed negotiation of the contract terms.