Real Options for Port Infrastructure Investments

P. Taneja, M.E. Aartsen, lA. Annema, M. van Schuylenburg

Abstract- Ports are a vital part of the maritime transportation system. The urgent need for redevelopment of

older ports and investments in port expansions, and the

dilemma of a long payback time etched with uncertainty calls for new strategies. Flexibilities in a (real) system, that enable it to change according to the future that unfolds, are known as real options. An evaluation technique, commonly known as Real Options Analysis, can be applied to value flexibility during project appraisal. This can improve decision-making related to port investments and asset management.

I. INTRODUCTION

Ports are a vital part of the maritime transportation system

and the economy of a nation. Port infrastructure includes

the entrance channels, berths, quay walls, cargo handling

equipment, storage yards and sheds, hinterland connections,

administrative buildings, and security structures. The global

trends in trade, transport, and logistics are placing increasing

demands on port infrastructures [1]. In addition to the routine

and restorative maintenance, there is an urgent need for

adaptation and redevelopment of older ports, and new

investments in port expansions. Added to the requirement of

huge capital investments in large scale infrastructures is the

dilemma of a long payback time for the investments, etched

with a great deal of uncertainty. All of these have led many in

the port sectors to seek new strategies to face and manage

these challenges.

Meanwhile, a new paradigm has replaced the conventional

notion that risk is undesirable [2] - [4]. It recognizes that risk

and uncertainty also provide opportunities, and that it is

important to reduce downside losses, and capture upward

opportunities. This can be done through incorporating

flexibility so that an infrastructure system can be adapted

according to the future that unfolds. Such flexibilities related

to real systems and projects are known as real options. These

can be built in a system, or be inherent to an engineering

Manuscript received July 1, 2010. This research is carried out within the framework of Port Research Centre Rotterdam-Delft and Next Generation Infrasructures, and sponsored by Water Research Centre Delft and Public Works Department Rotterdam.

P. Taneja is a part time researcher at Delft University of Technology (OUT), and is employed at the Public Works Department, Rotterdam as design engineer (p.taneja@tudelft.nl)

M.E. Aartsen is Investment Manager at the Port of Rotterdam Authority and advises the executive board on investment decisions, participations and other economic issues (me.aartsen@portofrotterdam.com)

lA. Annema is Assistant Professor Transport Policy at OUT and has worked at the Netherlands Environmental Assessment Agency and the Netherlands Institute for Transport Policy Analysis (j.a.annema@tudelft.nl)

M. van Schuylenburg is a Manager Projects at the Port of Rotterdam Authority and a technical expert in transport logistics. (m. van.schuylenburg@portofRotterdam.com).

system (though not always recognized). Incorporating

flexibility (i.e., a real option) into a system comes at a cost,

e.g., extra investments, or smaller stages investments which

can mean missing out on economies of scale, loss of market

and revenue, or project delays. A method for economic

evaluation, that enables planners to make a trade-off between

the value of incorporating flexibility and the cost of doing so,

is commonly given the name Real Options Analysis (ROA).

The use of this method is in general not widespread, and even

more limited in the maritime sector.

In this paper we examine how far the practices related to

investment decision making and asset management at the Port

of Rotterdam (PoR) can benefit from a real options approach

(which represents real options thinking and analytical

techniques). We attempt to find an answer to the following

questions through examining ports as infrastructure systems:

What are the limitations of the current evaluation methods

for Port of Rotterdam (Section UB)?

Which tools can help to evaluate the costs and values of a

system with flexibility (Section nC)?

What kind of flexible features does an infrastructure

system possess (Section IlIA)?

How can we recognize these features (Section IllB)?

What types of models are recommended to evaluate

projects facing major uncertainties in the port sector, such

as future demand and new technology (Section IV)?

Based on the answers, we draw conclusions in Section V over

the relevance and significance of modem evaluation methods

for the port sector.

n. EVALUATION METHODS

A. Standard practice at PoR

The Port of Rotterdam Authority (PoRA) is the developer

and manager of the PoR, the fourth largest port in the world.

It provides space, and invests in infrastructure for its clients in

addition to public infrastructure such as road-, rail-, inland

waterway and pipeline connections. The major goal, just as

any other private enterprise, is profit making for its

shareholders. Three types of projects can be distinguished at

PoR: site or real estate related client projects, public- or

nautical infrastructure related public projects, and a third

category which includes strategic and internal projects [5].

Only the client projects generate revenues for the port. Before

making an investment decision, a business case, which is a

test of the viability of a project, is set up. It forecasts the

present and future cash flows over the economic lifetime of

the project, and the financial feasibility of a project is

determined by applying discounted cash flow method (DC F)

which is standard practice for project appraisal world wide

for the last 30 years. An investment criterion of minimum

internal rate of return (IRR) of 8.5% has been set up for most

projects, and it is assumed that all risks are completely

accounted for by the discount rate.

The uncertain factors related to a project e.g., future cargo

flows, investment costs, project lifetime, raw material and

product prices, interest and exchange rates, tax and regulatory

policies, all have an impact on the projected cash flow. This

impact is taken into account by considering a certain positive

and negative variation around the base case scenario, which

results in an optimistic and pessimistic scenario. If a project

seems to face larger risks, say, because of uncertain demand,

a higher rate of return is used, or alternatively, the payback

period, normally set to 25 years, is reduced.

B. Limitations in the evaluation procedure

The decision making process with respect to project

investments is linear, and selects among a set of alternatives

to fulfill a project goal, without the possibility of interactions

or feedbacks. The (highly subjective) estimate of the discount

rate is likely to change over time with changing market

conditions and opportunity costs associated with other

projects at the firm. Further, the DCF method assumes that

decisions are made now, and will not change later, so that the

cash flow streams for future are fixed for the course of the

project. Flexibility in decision-making, design and

operations, enhances the value of a project, but cannot be

included in the standard DCF methods. This lack of suitable

analytical and evaluation techniques has been for long, a

barrier against investments in flexibility.

In summary, the financial techniques such as OCF method

are adequate for a stable environment, where the projects

have deterministic requirements and the management has a

clear strategy. But port projects, due to their long lifetime,

face the challenge of uncertainty, and require new techniques.

C. Real options analysis

Flexibilities related to real systems and projects are known

as real options (RO). RO can be created on decisions, or built

in physical infrastructures [6], [7]. These options are

extremely valuable in times of uncertainty. Among the many

modern evaluation methods, e.g., Decision Tree Analysis

(OT A), Monte Carlo Simulations, Real options Analysis

(ROA), and Portfolio optimization, ROA is said to have most

potential for investments under uncertainty [4], [14], [24].

RO for investment decisions have been mentioned in recent

government documents in the Netherlands [8], [9].

ROA is a systematic and integrated decision analysis

process, based on pioneering work by Black and Scholes in

1973. It is a technique that originated in the financial world

that now applies the thinking behind financial options to

evaluate physical or real assets. It is the right, but not the

obligation to take an action, affecting a real physical asset at a

predetermined cost, for a predetermined period of time [10].

ROA estimates the value of each cash flow stream by finding

a portfolio of traded securities that generates the same cash

flow stream and then uses the market value of this portfolio as

the estimate of market value of the cash flow stream. It uses

OCF methods as a building blocks (in fact, for a no

uncertainty situation, DCF is a special case of ROA), and uses

the same approach as OT A, but combines it with a consistent

valuation model.

III. FLEXIBILITY IN INFRASTRUCTURE PROJECTS

A. Introduction

Real options are sometimes embedded in a project, at other

times they have to be created and defined, through strategic

thinking, skilful negotiation, and wise investment decisions.

Infrastructure projects in general, permit integration of

physical attributes that makes flexibility in function, use and

operation feasible. Similarly, management generally

possesses a degree of flexibility in decision making (and can

use include mechanisms which permit this flexibility). These

two aspects of flexibility in infrastructures (Fig. 1) are

discussed here.

1) Flexibility in decision making ('on' infrastructures)

In most infrastructure investments, deferment or staged

investments are feasible. Phasing of major capital

investments allows taking advantage of new knowledge as

uncertainty clears with time. An example is the

pre-engineering phase, wherein environmental impact

studies, geotechnical surveys, traffic volume analysis or

market expectation studies are used determine the viability of

a project. Traditional valuation methods cannot evaluate the

benefits offered by these learning options.

Infrastructure projects are market or demand driven. In

port projects, the demand refers to cargo or ship traffic, and in

a real estate project, the demand could be for office or

housing space. Construction of such projects could be phased

in response to development of demand. The project could be

abandoned, expanded or contracted depending on demand

Fig.1 Types of flexibility in infrastructures

shifts or switched to another cargo sector or function.

An infrastructure project involves (long-term) contracts

with clients, financiers and construction contractors, all

involving much uncertainty. Yet other projects are high-risk,

consequently various mechanisms are included to deal with

such uncertainty by allowing parties to react to unexpected

events and to hedge against risks. These mechanisms can

include cargo guarantees, revenue guarantees, company

guarantees, partnerships, reduced payback period, etc. All of

these represent flexible options in a contractual package.

According to real options theory, all options have value and

should be included in the project evaluation.

Governments often grant various forms of support for

infrastructure projects, which may include a subsidy, a

guarantee or even a direct capital contribution, which would

add direct value to the project as well as indirect value by

attracting investors. The design of such contractual elements

is subjective due to shortfall in methods of evaluation. These

options must be accounted for in the negotiation stage or the

true value of the project might deviate substantially from

what was perceived at the onset of such an agreement [11]

[12]. ROA can be applied for designing such options.

2) Physical flexibility ('in' infrastructures)

Value can be created by building in physical options so that

a system can adapt in response to new or different functional

requirements. The result is a lengthened economic (useful)

lifetime and reduced risk of loss of investment. This is most

valuable if done early in a project. Some examples are:

designing a quay wall which can carry the weight of a future

larger crane, or a stronger foundation for vertical expansion

of a structure in the future. Another example is buildings

which are designed to be used both as houses and offices.

This means extra initial costs, but offers (in the strongly

cyclic office market), considerable flexibility advantages

later. Similarly, value can be created by incorporating options

that make flexible strategies during operation phase possible.

E.g., a quay wall used for handling inland ships in addition to

deep sea ships will provide operational flexibility for the

terminal operator, (though it requires extra investment in

equipment).

B. Identifying real options in projects

Real Options are not implicitly recognized by

organizations such as PoR since they do not form a part of the

DCF method, and real options thinking does not belong to the

firm's culture. A list of questions has been compiled on the

basis of a literature study [13] [14] in Table l. Answering

these questions can help a project manager to identifY if

flexible options exist in an infrastructure project. This is

illustrated with an example.

Case of a port project with options

In the period 1996-1999, PoR formed a consortium with

one of its clients Odfjell Terminals Rotterdam BV and some

other firms, to investigate the innovative concept for storage

of oil products in a quay wall. Besides the expected benefits

due to multi-functionality, this would win (scarce) space in

the existing port. After an initial economic evaluation, if the

innovative alternative proved non-viable, a traditional quay

wall with a single function of mooring ships would be

constructed for the client. A lot of time, money and research

and engineering effort went into developing a technically

feasible design concept. However, this innovative design

proved to be expensive, and when the business case for

various parties proved to be non-viable, the project was given

a no-go. The traditional alternative was selected. An analysis

of the project, based on criteria in Table 1, follows.

The success criterion with respect to this project is profit

(measured in terms of IRR). The major source of uncertainty

is the economic feasibility of the innovative alternative; this is

mainly a market risk. This uncertainty will not be resolved

over a short time, and since the client needs the facilities

soon, the decision cannot be postponed. The project involves

contingent decisions; therefore, the decision-making can be

phased. The first phase will involve conceptual designs and

estimation, after which one of the two alternatives will be

selected. The second phase will involve construction of the

selected alternative. Flexibility in changing project direction

is available only at the end of first phase. This project can

create growth opportunities, since the innovative

multi-functional quay concept can be used at various

locations and for many clients in the port, and save scarce

space. Such a project has following options embedded in it

(Table 2), which can be exercised by the owner of the options,

i.e., PoRA.

Option

TABLE 1 IDENTIFYING REAL OPTIONS

Establish success criteria

What is the success criterion with respect to this project? Reduce uncertainty

What are the sources of uncertainty in this project? Can you shape this uncertainty? Can you do research get more information on the uncertainties? Can you insure or hedge against some of the risks? Can you transfer risks to those that are most capable to manage them?

IdentifY managerial options

Are the sources of uncertainty in this project private or market risks? When will the uncertainty be resolved? Is it advantageous to postpone decisions? Can decision-making be phased? Are there contingent decisions in the project? Is there flexibility in changing project direction to maximize its value? What is the investment cost in relation to the estimated payoff? Will this project create other growth opportunities? If so, is it possible to include their potential value in the business case? What are the actions required to obtain or retain flexibility? Can project be abandoned after the start and salvage value collected?

IdentifY design options

Can some of the following be incorporated in the design? Modularity Adaptability to changing functions Evolvability with reference to new technology

IdentifY operational options

Can the processes/ operations be made flexible? Set up decision rules

What are the actions req uired to change strategy? What is the decision rule for changing strategy?

TABLE 2

OPTIONS AVAILABLE IN ODFJELL PROJECT

o tion Do nothing option Build a new quay wall Form a collaboration Invest in a feasibility study of innovative infrastructure Choose traditional alternative in place of innovative solution Lease extra quay capacity to another client Sell design concept to another client Negotiate revenue guarantees with Odfjell Terminate collaboration *Sell assets/ share in projects

T e

growth option

staging and learning option switching option put option put option

abandonment option

Initiate arbitration process in case of breach call option of contract, claimin com ensation

* As landlord port PoR would NOT exercise this option

It is possible to include the potential value of many of these

options in the project value through an ROA, in which case,

the business case might have been feasible. Through real

options thinking, the parties could have recognized that the

investment in the first phase was a learning option. It would

result in an option of being able to sell the innovative concept

to other port users to be applied at other locations in the port.

The business cases were based on a ceiling price which

included quantified risk in categories such as unexpected

events and incomplete design due to innovative nature of the

project. In reality, these risks would be much lower for

subsequent projects. Even in absence of exact quantification,

revealing these options to the management might have

convinced them to select the innovative solution, instead of

the traditional solution.

IV. REAL OPTIONS METHODS FOR PORT OF ROTTERDAM

A. Introduction

This section discusses real option models for dealing with

the major uncertainties in port projects and their limitations. It

also makes recommendations that could prove beneficial for

projects and situations at PoR

B. Real options modelling for port projects

The selection of a real options model begins with

identification of uncertainties in the system, which require

flexible solutions. The major uncertainties for ports are

demand and future technology (e.g., evolution in ship sizes

and in equipment, transport-, handling- and logistic

concepts). Flexible options incorporated in designs to handle

these uncertainties can be valued using methodologies

indicated in Table 3 based on [15].

If the value of the flexible design is defined solely by the

(single) uncertain market variable, financial methods may be

used to provide guidance on the value of the flexible design.

These include the Black-Scholes formula for call options

[16], [17], and the binomial lattice model [18], [19].

If the major source of uncertainty is a non-market variable

or if the market variable is an input to another function that

determines project value and exercise is based on economic

rather than physical terms, then a simulation model based on a

cost-revenue model under uncertainty is appropriate [10],

[20], [21]. The economic criteria could be the NPV, the

payback period, or even total costs over the lifecycle of the

infrastructure in case the benefits are difficult to estimate. The

objective, in most cases, is to compare alternatives (designs

with or without different forms of flexibilities)

If exercise of the design's flexibility depends on how the

system performs physically in the future, a simulation model

that includes an engineering model of the system's physical

performance under uncertainty is needed.

Some examples of evaluation of projects with managerial

options using Black-Scholes formula and binomial models

can be found in [14], [24], but their applicability for PoR

market in their current form needs more research, as

discussed in the following section.

C. Limitations of ROA for the PoR market

The financial option pricing models assume that the rate of

return on the underlying asset is lognormally distributed, the

prices are random which assures that markets are competitive,

and allows pricing models to work; the volatility is known

TABLE 3

EVALUATION MODELS FOR PORT PROJECTS

Uncertainty Demand throu2hput Future technolo2Y Type of market non-market uncertainty

Source of historical data, expert expert opinion, iriformation opinion, monitoring monitoring external

external environment environment Evaluation - Monte Carlo model based Monte Carlo simulation model on cost- revenue model based on cost-

revenue for flexible designs

Assumptions/ - Exercise based on Exercise based on Requirements economic criteria- economic criteria rather

Financial model requires than physical path independence and a performance complete market

Limitations choice of probability choice of probability distributions and discount distributions and rate is subjective discount rate is

subjective

and constant and complete liquidity of the underlying asset

[14]. The port market is very different from the financial

market, which limits the use of RO models based on options

theory for the port market in Rotterdam

Firstly, the value of an engineering project depends on the

path taken, whereas the value of stocks is determined solely

by supply and demand. New venture or activities can

influence the project value, so that the criteria of path

independence are not met.

Secondly, the port market cannot be called a complete

market. The port dues and land lease rent are the main sources

of revenue for the PoR (approx. in the ratio 55% and 45%).

Often, concessions or subsidy arrangements in the contractual

agreements with the terminal operator are incorporated to

shape demand or limit risks. The current practice is to hedge

against the market risks by means of guarantees which lead to

a minimum return on investment of 6% - 7% for client related

projects. The other major source of income is the land lease

tariffs which are determined per project by the PoRA (land

owner), based on a variety of considerations. The land market

thus does not conform to requirements of a complete market.

The more or less monopolistic position of PoR may also

contribute to the market imperfection.

Complete markets also assume that all external effects have

been internalized. However, costs such as the costs of

congestion (resulting in reduced handling capacity and

service quality and can therefore be seen as lost revenues) are

generally not discounted in the price. Similarly, benefits such

as increased efficiency due to clustering of similar companies

are also not included in the revenue figures.

Models based on options theory require quality data over

costs and revenue as well as an insight in the volatility of

these parameters. Financial markets, with innumerable

transactions involving valuation of stocks, have enough data

for volatility estimation, but other markets may be different.

Simulation models, on the other hand, can prove useful in

supporting decision making. And real options thinking, or a

qualitative approach to real options can make enormous

contribution as well, as discussed in the following section.

D. Recommendations for PoR projects

Having examined various evaluation methods for port

projects and markets, we will now make some

recommendations that could benefit projects and situations at

PoR.

1) Business case under uncertainty

A simulation model using historical data if available, and

otherwise, expert opinion to define the distribution of

uncertain variables, as well as the relationship between the

variables, seems to be the most realistic for evaluation of port

projects. The source of uncertainty is expressed as a value

function in a cash-flow model. The resulting probability

distribution of NPV and additional statistical parameters

provide relevant and more complete information for financial

analysts and decision makers. This requires little effort, and

the results are easy to understand.

Phasing should be incorporated in all projects if the

investment horizon is sufficiently long, and if feasible within

the constraints of the client's requirements, procedures and

legalities. Phasing provides the option to alter plans (e.g.,

speed up, defer, or abandon a project) in case of altered

circumstances. Maasvlakte 2 is an ongoing port expansion

project requiring extensive construction. Phased construction

gives PoR the option to abandon the following phase of the

project, and avoid a part of the capital expenditure if the

market deteriorates.

PoR is exploring investment opportunities in foreign ports.

ROA using simulations can be a useful tool for selecting

between different locations, which offer different

combinations of land purchase costs, local and state taxes,

and supporting infrastructure.

2) Valuingflexibility

Flexibility in design, operations, and management

decision-making can enable the managers to develop

strategies to react to changing circumstances, take advantages

of opportunities and insure themselves against downside risk.

Simulation models can be applied to evaluate the value of this

flexibility in designs. Examples can be found in [21], where

the design of a flexible quay wall for bigger future ships, and

a flexible design of mooring dolphins with reserve capacity

have been evaluated.

3) Incorporating and valuing contractual options

Cargo-guarantees, revenue-guarantees, collaborations,

partnerships, reduced payback period etc., all represent

flexible options in a contractual package and should be

included in the project evaluation.

4) Research and development and innovation

PoR has an extensive R&D agenda, which focuses on

product, process and social innovation. E.g., PoR is debating

on pilot projects in the existing Rotterdam area in order to

study the feasibility of multi-user terminals. These would

increase the utilization rate of existing quay waJls and result

in flexibility for the users. The initial effort of such pilot

projects is small, and the subsequent phase need only be

initiated if the results are promising. This creates upside

opportunity while reducing downside risks. Similarly the

planned innovative projects, e.g. in cooperation with General

Electric can be seen as learning options justifying

investments [22].

5) Flexibility considerations (real options thinking)

According to [23], analytical, quantitative tools, even ones that can model dynamic decision-making, are not able to model the more qualitative nature of uncertainty. But in the face of high uncertainty, a qualitative approach to the finance side of project analysis is also essential. The RO framework

could be used to - qualitatively define, structure, and understand a project's uncertainties; recognize the value of flexibility in decision making; formalize the problem of choosing among technically feasible alternative forms of flexibility; help decision-makers to consider options that might be ignored at time nil, thus decreasing economic exposure to risk.

V. CONCLUSIONS

Infrastructure projects often encompass flexible options

which may be physical or managerial in nature. Such

flexibilities related to real systems and projects are known as

real options. Traditional economic analysis does not include

the value of this flexibility, and grossly underestimates the

true intrinsic value of a project.

Flexibility, innovation, and research and development are

crucial for success of projects, but involve extra costs. These

costs can be justified if included in the economic analysis as

valuable options which can result in future benefits.

Simulation models seem to be most relevant of all proposed

analysis techniques, for engineering projects and for the PoR

market. Such an analysis requires time and effort, but it

reveals the true potential project value, which facilitates

better decision-making for project appraisal and asset life

cycle management. Real options thinking compels decision

makers to take into account a life cycle perspective and

consider flexible options which will decrease economic

exposure to risk.

The following sequence of steps is recommended

pertaining to projects at Port of Rotterdam:

Qualitatively define, structure, and understand a project's

uncertainties;

Consider all available investment alternatives at time zero

(including 'no-project option' or 'change policy');

Recognize the value of flexibility and include flexible

design alternatives;

Include flexible strategies (e.g. staging, delay, growth,

engineering processes are amenable to this);

Describe the possible futures with decision trees and

future uncertainties with probability for added insights;

Apply DCF, simulations, decision tree analysis or real

options analysis depending on the situation (objective of

analysis, validity of assumptions, ease of use and

interpretation).

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