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Environmental Energy Technologies Division
Michael Smurfit Graduate School of Business
Real Options Valuation of US Federal Renewable Energy Research, Development, Demonstration, and
Deployment
paper presented at the
Tenth Annual POWER Research Conference onElectricity Industry Restructuring
by
Afzal S Siddiqui++University College Dublin - [email protected] – tel: +353 (0)1 716 8091
coauthors: Chris Marnay,# and Ryan H Wiser*
#Berkeley Lab - [email protected] – tel: +1.510.486.7028*Berkeley Lab – [email protected] – tel: +1.510.486.5474
(with research assistance by Mark A Bolinger, Kristina Hamachi LaCommare, and Etan Gumerman)
This work sponsored by the Office of the Assistant Secretary for Energy Efficiency and Renewable Energy, Office of Planning, Budget, and Analysis, of the U.S. Department of Energy, and the Business Research Programme of the Michael Smurfit Graduate
School of Business at University College Dublin
2
Environmental Energy Technologies Division
Michael Smurfit Graduate School of Business
Outline
• Background and Theory of Real Options
• Model Formulation
• Numerical Results
• Conclusions
3
Environmental Energy Technologies Division
Michael Smurfit Graduate School of Business
Background •US Federal government funds renewable energy (RE) technology
research, development, demonstration, and deployment (RD3)
•Motivated by concerns over stable supply of non-renewable energy (NRE), since at least the oil embargo of 1973
•Discovery of new oil fields and improvement in petroleum extraction methods in 1980s decreased NRE costs
•A purely deterministic analysis ignores insurance value of existing RE technologies and future RD3 arising from uncertain NRE costs
• Argues that RE RD3 should be abandoned since it is a negative NPV investment
•National Research Council (a component part of the National Academy of Sciences) surveyed DOE research in 2001
• Identified realised benefits (based on deterministic forecasts), options benefits (addressed here), and knowledge benefits (spin-off and academic returns)
4
Environmental Energy Technologies Division
Michael Smurfit Graduate School of Business
Background – Real US Natural Gas
Fuel Generation Costs
0.00.51.01.52.02.53.03.54.04.55.0
2002
-¢/k
Wh
source: EIA natural gas wellhead price (http://tonto.eia.doe.gov/dnav/ng/hist/n9190us3m.htm)
5
Environmental Energy Technologies Division
Michael Smurfit Graduate School of Business
Real Options
•Options give the holder the right (but not the obligation) to buy or sell a security at a fixed strike price by a certain date in the future
•Investment projects also have value deriving from managerial discretion to reduce, expand, or delay effort
•Public investment in RE RD3 can be thought of as a (compound) real option
•Since the underlying security’s price is stochastic, it is possible that the option has positive value even if deterministically it does not
•This work follows:– Brennan and Schwartz (1985) (proposes an options approach to a mine investment problem)– Davis and Owens (2003) application of real options to US Federal
RE RD3
(uses complex model requiring finite differences method, suggesting need for a more intuitive approach)
6
Environmental Energy Technologies Division
Michael Smurfit Graduate School of Business
Disaggregated RE Technology Benefits
Real Options Valuation of RE RD^3
0.0E+00
2.0E+10
4.0E+10
6.0E+10
8.0E+10
1.0E+11
1.2E+11
Case 1 Case 2 Case 3A Case 3B
US
$ (
20
02
)
Options Value of AbandonmentFlexibility
Options Value of Continued RD^3
Options Value of Existing RETechnologies
7
Environmental Energy Technologies Division
Michael Smurfit Graduate School of Business
Outline
• Background and Theory of Real Options
• Model Formulation
• Numerical Results
• Conclusions
8
Environmental Energy Technologies Division
Michael Smurfit Graduate School of Business
Binomial Lattice Representation for a Plain American Call Option
S(0,0)
S(1,1)=uS(0,0)
S(1,0)=dS(0,0)
p
1-p
p
p
1-p
1-p
S(2,2)=uS(1,1)
S(2,1)=uS(1,0)
S(2,0)=dS(1,0)
ikVpikpVeEikSikV ,111,1,,max,
9
Environmental Energy Technologies Division
Michael Smurfit Graduate School of Business
Transition Diagram for the RE RD3 Real Options Problem
10
Environmental Energy Technologies Division
Michael Smurfit Graduate School of Business
RE RD3 Real Options Problem SDP
•Use binomial lattice approach to set up a SDP for the RE RD3 problem
jrikWpjrikWpMkjXrkCikSjrikW ,,,11,,1,1,,,,,,
;1,,111,1,1
;,,,
;
max,,
rikVprikVpMR
DkrikW
A
rikV
11
Environmental Energy Technologies Division
Michael Smurfit Graduate School of Business
Outline
• Background and Theory of Real Options
• Model Formulation
• Numerical Results
• Conclusions
12
Environmental Energy Technologies Division
Michael Smurfit Graduate School of Business
Input Parameters
Parameter Description Unit Case 1
Case 2
Case 3A
Case 3B
C(0,0) initial cost of renewably generated electricity
(RE) ¢/kWh 6
same as 1
same as 1
same as 1
C(n,0) terminal cost of renewably generated electricity
WITHOUT RD3 ¢/kWh 6
same as 1
same as 1
same as 1
C(n,n) terminal cost of renewably generation electricity
WITH RD3 ¢/kWh 5
same as 1
same as 1
same as 1
S(0,0) initial cost of non-renewably generated electricity
(NRE) ¢/kWh 4.5
same as 1
same as 1
same as 1
n number of time periods years 20 same as 1
same as 1
same as 1
α risk free interest rate, average 3-month T-bill,
1984-2003 % 2.4
same as 1
same as 1
same as 1
β discount factor 0.976 same as 1
same as 1
same as 1
σ volatility parameter – standard deviation of
historic percentage price movements % 12 20 3 6
p probability of a price increase in each period 0.571 same as 1
same as 1
same as 1
R annual RD3 expenditure M$ 250 same as 1
same as 1
same as 1
A one-time abandonment cost M$ 250 same as 1
same as 1
same as 1
M maintenance cost after deployment M$ 0 same as 1
same as 1
same as 1
X(j,k) excess demand TWh/a see figure
same as 1
same as 1
same as 1
13
Environmental Energy Technologies Division
Michael Smurfit Graduate School of Business
Available Load for Renewably Generated Energy
0
200
400
600
800
1000
1200
TW
h/a
14
Environmental Energy Technologies Division
Michael Smurfit Graduate School of Business
Implied Forecast of NRE Costs and Historic Data
0
2
4
6
8
10
12
14
16
18
20
2002
-¢/k
Wh
78% probability range
AEO2004 projection
Historic and Projected Mean NGCC Levelized Cost
3.5 ¢/kWh
14.9 ¢/kWh
7.3 ¢/kWh
5.2 ¢/kWh
0.00
0.05
0.10
0.15
0.20
0.00 0.10 0.20 0.30 0.40 0.502002-$/kWh
Dis
trib
uti
on o
f P
rob
abil
ity Expected Value = 0.073 $/kWh
Source: Combination of EIA historic and AEO2004 forecast data, including analysis results
15
Environmental Energy Technologies Division
Michael Smurfit Graduate School of Business
Results
• Overall real options value of RE technology increases with volaility of NRE cost
• Greater uncertainty makes existing and RD3-enhanced RE technology more valuable
• Higher chance of extremely high NRE costs with a bounded (by zero) downside
• Value of existing RE technology increases with NRE cost volatility • This measures the difference between the NRE cost and the 6 ¢/kWh
initial RE cost• As NRE costs become more volatile, this difference increases, thereby
raising the value of existing RE technologies
• Counterintuitively, the incremental value of ongoing RD3 decreases with volatility
• RD3 decreases cost of RE, but effect is capped at 1 ¢/kWh • High volatility induces early adoption and low overal RD3 progress• This forecloses future RD3 and diminishes its proportion in the overall
value
• Flexibility to abandon the RE programme is insignificant and covaries positively with NRE cost volatility
• Provides downside protection, the danger of which occurs only in a world with high NRE cost volatility
16
Environmental Energy Technologies Division
Michael Smurfit Graduate School of Business
Aggregated RE Technology Benefits (Billion 2002US$)
Case Total Real
Options Value Case 1: low gas volatility 70 Case 2: high gas volatility 104
Case 3A: 75% coal-25% gas 36 Case 3B: 50% coal-50% gas 46
17
Environmental Energy Technologies Division
Michael Smurfit Graduate School of Business
Results – Options Value of Existing RE Technology
• Overall real options value of RE technology increases with volaility of NRE cost
• Greater uncertainty makes existing and RD3-enhanced RE technology more valuable
• Higher chance of extremely high NRE costs with a bounded (by zero) downside
• Value of existing RE technology increases with NRE cost volatility and also increases as a proportion of the overall value
• This measures the difference between the NRE cost and the 6 ¢/kWh initial RE cost
• As NRE costs become more volatile, this difference increases, thereby raising the value of existing RE technologies
• Counterintuitively, the value of ongoing RD3 decreases with NRE cost volatility
• RD3 decreases cost of RE, but only by 1 ¢/kWh • High NRE cost volatility induces early adoption of RE technology• This forecloses future RD3 and diminishes its proportion in the overall value
• Flexibility to abandon the RE programme is insignificant and covaries positively with NRE cost volatility
• Provides downside protection, the danger of which occurs only in a world with high NRE cost volatility
18
Environmental Energy Technologies Division
Michael Smurfit Graduate School of Business
Disaggregated RE Technology Benefits
Real Options Valuation of RE RD^3
0.0E+00
2.0E+10
4.0E+10
6.0E+10
8.0E+10
1.0E+11
1.2E+11
Case 1 Case 2 Case 3A Case 3B
US
$ (
20
02
)
Options Value of AbandonmentFlexibility
Options Value of Continued RD^3
Options Value of Existing RETechnologies
19
Environmental Energy Technologies Division
Michael Smurfit Graduate School of Business
Results – Options Value of Ongoing RD3
• Overall real options value of RE technology increases with volaility of NRE cost
• Greater uncertainty makes existing and RD3-enhanced RE technology more valuable
• Higher chance of extremely high NRE costs with a bounded (by zero) downside
• Value of existing RE technology increases with NRE cost volatility and also increases as a proportion of the overall value
• This measures the difference between the NRE cost and the 6 ¢/kWh initial RE cost
• As NRE costs become more volatile, this difference increases, thereby raising the value of existing RE technologies
• Counterintuitively, the value of ongoing RD3 decreases with NRE cost volatility
• RD3 decreases cost of RE, but only by 1 ¢/kWh • High NRE cost volatility induces early adoption of RE technology• This forecloses future RD3 and diminishes its proportion in the overall value
• Flexibility to abandon the RE programme is insignificant and covaries positively with NRE cost volatility
• Provides downside protection, the danger of which occurs only in a world with high NRE cost volatility
20
Environmental Energy Technologies Division
Michael Smurfit Graduate School of Business
Disaggregated RE Technology Benefits
Real Options Valuation of RE RD^3
0.0E+00
2.0E+10
4.0E+10
6.0E+10
8.0E+10
1.0E+11
1.2E+11
Case 1 Case 2 Case 3A Case 3B
US
$ (
20
02
)
Options Value of AbandonmentFlexibility
Options Value of Continued RD^3
Options Value of Existing RETechnologies
21
Environmental Energy Technologies Division
Michael Smurfit Graduate School of Business
Results – Options Value of Abandonment Flexibility
• Overall real options value of RE technology increases with volaility of NRE cost
• Greater uncertainty makes existing and RD3-enhanced RE technology more valuable
• Higher chance of extremely high NRE costs with a bounded (by zero) downside
• Value of existing RE technology increases with NRE cost volatility and also increases as a proportion of the overall value
• This measures the difference between the NRE cost and the 6 ¢/kWh initial RE cost
• As NRE costs become more volatile, this difference increases, thereby raising the value of existing RE technologies
• Counterintuitively, the value of ongoing RD3 decreases with NRE cost volatility
• RD3 decreases cost of RE, but only by 1 ¢/kWh • High NRE cost volatility induces early adoption of RE technology• This forecloses future RD3 and diminishes its proportion in the overall value
• Flexibility to abandon the RE programme is insignificant and covaries positively with NRE cost volatility
• Provides downside protection, the danger of which occurs only in a world with high NRE cost volatility
22
Environmental Energy Technologies Division
Michael Smurfit Graduate School of Business
Disaggregated RE Technology Benefits (Billion
2002US$)Cases
Total Real Options Value
Value of Existing RE
Technologies
Value of Future RE
RD3 Enhancement
s
Value of RD3 Abandonment Flexibility
Case 1: low gas volatility
70 63 7.4 0.22
Case 2: high gas volatility
104 97 6.2 0.34
Case 3A: 75% coal-25% gas
36 21 15 0.00
Case 3B: 50% coal-50% gas
46 35 11 0.06
23
Environmental Energy Technologies Division
Michael Smurfit Graduate School of Business
Outline
• Background and Theory of Real Options
• Model Formulation
• Numerical Results
• Conclusions
24
Environmental Energy Technologies Division
Michael Smurfit Graduate School of Business
Conclusions • Deterministic DCF approaches vastly undervalue the benefits of
RE RD3
• Use real options model to introduce uncertain NRE costs via SDP
• Determine significance of each component of the compound option
• Find most of the benefits accrue due to existing RE technology
• Inability of model to permit RE RD3 after deployment creates situation for a perverse result in which value of RD3 decreases with volatility
• Other limitations:• Technical risk• Regime switching• Re-initiation of RD3 once stopped• Only a single, representative RE technology
25
Environmental Energy Technologies Division
Michael Smurfit Graduate School of Business
Davis and Owens (2003)
• Assume NRE cost evolves according to GBM, while RE cost can be lowered with RD3 funding
• Technical risk also exists in RE RD3
• Initial deterministic DCF analysis yields NPV of –US$35.3 billion
• Improved DCF approach that allows for optimal timing indicates NPV of US$4.8 billion
• Full real options model values the RD3 programme at US$30.6 billion
• Uncertainty in two dimensions forces use of finite differences method• Does not convey the economic intuition inherent in managerial flexibility
• Results reveal that 86% of value is due to RE technologies already in place• However, not clear how this and the value of ongoing RD3 vary with model
parameters
26
Environmental Energy Technologies Division
Michael Smurfit Graduate School of Business
Real Options
• Concept of options not restricted to financial transactions
• Investment projects also have this value that derives from managerial discretion to expand, delay, or abandon as information is received
• Classic application: Brennan and Schwartz (1985)• Value a copper mine by deciding how to operate it• Set of feasible decisions each period: extract, suspend, or
abandon• Profit in an extraction period is the difference between the
stochastic copper price and the operating cost of the mine• This is akin to evaluating a compound option
• Other relevant works:• Huchzermeier and Loch (2001)• Grenadier and Weiss (2001)• Deng and Oren (2003)
27
Environmental Energy Technologies Division
Michael Smurfit Graduate School of Business
NRE Cost Dynamics
du
depeudeu
duSikS
kinkikSdikS
kinkikSuikS
iki
and,1,
where
0,0,
0and0p,1yprobabilitimpliedwith,,1
and
0and0p,yprobabilitimpliedwith,1,1
• Assume NRE cost follows a GBM process• Successive percentage changes are independent of previous
ones• Discretise as follows:
28
Environmental Energy Technologies Division
Michael Smurfit Graduate School of Business
Limitations of the Model
• Ignore technical risk, i.e., RE RD3 deterministically decreases future RE costs
• Done in order to focus on market risk
• Do not allow RD3 to be re-initiated once stopped
• Prohibit RD3 to continue once RE technologies are deployed
• NRE cost follows a GBM process rather than a regime switching one
• Regime switching not implemented in model, but important from policymaking perspective
• Over a long time horizon, GBM is not inaccurate
• Forecast the residual energy available for RE based on a single, representative RE technology