The lack of economic incentives and uncertainties in recovering the cost of a merchant / economic transmission project is an area of great concern as aging and heavy loading conditions limit the capability of the U.S. transmission networks. Merchant transmission projects are envisioned as market based solutions to enhance the power grid and to import cheaper energy from power suppliers in other areas. However, due to uncertainties in the electric energy market, market based cost recovery mechanisms have not been successful in guaranteeing a full recovery of the investment. As a result, few merchant projects have been built. This dissertation presents a comprehensive analysis of merchant transmission projects and the required economic incentives that are necessary to enhance the power grid.

The concept of perpetual options theory is initially introduced to analyze merchant transmission investment through an approved rate. Since the electric usages and the associated revenue are stochastic in nature, applying the perpetual options theory allows an investor to determine the most opportunistic time to start a transmission project and obtain the maximum revenue returns or let the option expire when the economic incentive is not sufficient. In today's environment, this decision approach is more appropriate since it provides transmission investors a better evaluation of its return on investment and an exit strategy for an investment. The probability of not recovering the capital investment associated with an exercise of the option to build is calculated using Kolmogorov forward equation. The risk of an exercise is needed for decision making of the investment and for assessing the incentive needed to encourage transmission investment.

A market based transmission rate is designed as an additional incentive for merchant projects. The new rate design provides additional revenues to transmission developers in order to attract the transmission investment. The rate takes into consideration the revenue requirement by the developer and benefits to transmission customers. Finally, a conceptual framework to analyze the strategic interaction between power plant investment and transmission line investment is proposed. The model, which is based on game theory, helps to evaluate different market incentives and the impact of generator's decision on transmission enhancement projects.