environmental energy technologies division michael smurfit graduate school of business 1 real...

1

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



Outline

• Background and Theory of Real Options

• Model Formulation

• Numerical Results

• Conclusions

3



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



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



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



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



Outline




• Conclusions

8



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



Transition Diagram for the RE RD3 Real Options Problem

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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



Outline




• Conclusions

12



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

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Available Load for Renewably Generated Energy

0

200

400

600

800

1000

1200

TW

h/a

14



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



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

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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

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Results – Options Value of Existing RE Technology




• 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



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0.0E+00

2.0E+10

4.0E+10

6.0E+10

8.0E+10

1.0E+11

1.2E+11


US

$ (

20

02

)




19



Results – Options Value of Ongoing RD3











20





0.0E+00

2.0E+10

4.0E+10

6.0E+10

8.0E+10

1.0E+11

1.2E+11


US

$ (

20

02

)




21



Results – Options Value of Abandonment Flexibility











22



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



Outline




• Conclusions

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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

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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

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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)

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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:

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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

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