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Journal of Business Economics
Erschienen in: Journal of Business Economics 3/2019

06.08.2018 | Original Paper

A real option application for emission control measures

verfasst von: Carmen Schiel, Simon Glöser-Chahoud, Frank Schultmann

Erschienen in: Journal of Business Economics | Ausgabe 3/2019

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Abstract

Real Option analyses are broadly discussed in economics and finance and different analytic and numeric calculation methods for option values have been presented and successfully implemented in theoretical case studies and practical applications. However, real option analysis has not yet been applied for mandatory investments without monetary revenues, e.g. investments in pollution reduction and emission control installations in large industrial plants enforced by political regulation. The assessment of the timing of the investment, i.e. whether to invest immediately or to delay the investment in the future, is the main scope of this work. A difficulty of the underlying type of investments with regard to option valuation is that not to invest is not an option. Therefore, the frequently applied optimal stopping approaches based on investment thresholds are not applicable to this work. In the first part of the paper, specific features and characteristics of the regarded investments are analyzed and translated into financial terms of option valuation, accompanied by an overview of several relevant option valuation methods. The most appropriate methodology for the application, the Monte-Carlo-Analysis, will be assessed in more detail. Based on a two perspectives approach that analyzes possible savings and losses of a delayed investment, a case study displays the calculations and results of the developed methodology in several scenarios. The case study reveals possible influences of policy schemes and the impact of the degree of uncertainty on mandatory investments. The work has a strong methodological focus and the calculation methodology provided can be of use for investors and policy-makers, particularly with regard to investment decision-making in the real options framework and the design of political instruments such as funding schemes.
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Fußnoten
1
COP: annual Conference of the Parties of The United Nations Framework Convention on Climate Change (UNFCCC). More information on the Convention and the outcomes of the Conferences are provided on the website of the Convention: UNFCCC (2014).
 
2
They cannot compete with other revenue gaining investments from an economic and company internal view, i.e. if externalities are not taken into account.
 
3
This publication is supposed to contain errors in the analytical solution of the optimal stopping problem, which have been identified and solved numerically in Balikcioglu et al. (2011). Nevertheless, the general approach is of relevance for succeeding publications and shall hence be mentioned here.
 
4
Even though NOX and PM became more prominent in political discussions recently, there are only a few market-based or direct monetary policy instruments (e.g. fees or taxes) implemented for these pollutants worldwide. For NOX, cf. Mayer et al. (2016).
 
5
An exemplary study is provided in Chronopoulos et al. (2016), the importance of staging options and choices as a key element of strategy is also described in Trigeorgis and Reuer (2017) and Hambrick and Fredrickson (2001).
 
6
There are several more subcategories and exotic options in the financial literature (cf. e.g. Rieger 2016), in the scope of this work, however, this standard categorization appears sufficient.
 
7
The strike price is the price noted in an option contract that has to be paid for the underlying asset when exercising the option (cf. Hull, 2012, p. 7).
 
8
Even though the decision itself may be made at any time, it is considered accurate enough to allocate investment decisions at certain time steps.
 
9
Usually caused by political instruments such as emission fees, taxes, trading schemes, etc.
 
10
A levered hedge or riskless portfolio is a portfolio of assets that achieves the same outcome at the end of its life no matter which way the price of the share moves. A detailed explanation is provided in Hull (2012, p. 254) and Peters (2016, p. 36).
 
11
In RO application, the stochastic process is often a Geometric Brownian Motion, but other processes such as Markov jump processes, mean-reverting processes or any other kind of stochastic process can be assessed as well.
 
12
Important publications in this field are summarized by Baecker et al. (2003, p. 30) and Mostafa and Dillon (2008) and recently by Yang et al. (2017).
 
13
With regard to the given application, particularly jump processes are considered highly relevant, as changes in policy regimes typically occur stepwise and not as a continuous movement.
 
14
Future prices may not only vary between a high and a low level but the whole range in between is also possible. Therefore the number of branches increases uncontrollably if major simplifications shall be avoided.
 
15
The remaining lifetime of the plant is particularly relevant in case of retrofits.
 
16
Cash flows are primarily caused by fixed and variable operating costs and emission fees, if applicable. Revenues are not considered as described above. In certain cases, there may be revenues, for example resulting from the selling of by-products, yet by definition, the expenditures always excel the revenues significantly.
 
17
Emission fees, if applicable, are usually induced by political instruments such as taxes, trading schemes, etc.
 
18
Reinvestments could be considered in order to create periods of the same length. However, this appears highly uncertain in such a volatile environment with comparably long lifetimes of investments. Therefore, reinvestments will not be considered in the following.
 
19
Assuming that L represents the total considered lifetime of the installation starting from t0.
 
20
In this work, the imputed interest is selected as a suitable measure for the option price. However, if a specific investment is known to cause higher or lower costs when being delayed, this value may be adjusted.
 
21
t* needs to succeed t, therefore t* > t.
 
22
Cf. Sect. 2, options in the money are those options that are reasonable to be executed from an economic point of view. In the given context, executing the option, i.e. advancing the investment, gains savings for paths in the money.
 
23
As t0 is the current decision-making period, it is always the reference period in the minimum losses perspective.
 
24
The constraint mentioned in footnote 20 with regard to the calculation of the OP applies accordingly.
 
25
ERICCa_LCP: Emission Reduction Investment and Cost Calculation for Large Combustion Plants.
 
26
TFTEI: Task Force on Techno-Economic Issues. Current versions of the tool are published regularly on tftei.citepa.org.
 
27
These assumptions may be questionable in practical applications, yet they facilitate the reproduction of the calculations.
 
28
The reasons for the comparably low interest rate have already been discussed in Sect. 4.1 (cf. also Umweltbundesamt 2012).
 
29
t is the time of the considered execution of the investment. As the decision-making focusses on the current period t0 (the question is whether to invest now or to delay the investment), all operating costs are discounted to t0, even though the investment may be executed later and operating costs do not occur prior to t. This contemplation will be helpful for the subsequent calculations.
 
30
The OP in Table 4 are calculated and displayed from time τ1 to τ2, with τ1 displayed in the columns and τ2 in the lines.
 
31
This is caused by the highest relative increase of the investment in the first period and the effect of the time value of money.
 
32
Environmental fees usually affect operating expenses rather than investments, yet the behavior of the methodology remains the same.
 
33
The derivation of an investment decision is hardly meaningful in this case, as the underlying scenarios do not represent realistic and comparable scenarios with regard to expectations of future developments, but are stylized independent examples. Nevertheless, the results are mentioned in order to explain the calculation procedure. Section 5.3 provides a more meaningful example and the corresponding results.
 
34
This assumption holds in the given applications, as the investor is only obliged to invest but not to execute the option of advancing or delaying the investment.
 
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Metadaten
Titel
A real option application for emission control measures
verfasst von
Carmen Schiel
Simon Glöser-Chahoud
Frank Schultmann
Publikationsdatum
06.08.2018
Verlag
Springer Berlin Heidelberg
Erschienen in
Journal of Business Economics / Ausgabe 3/2019
Print ISSN: 0044-2372
Elektronische ISSN: 1861-8928
DOI
https://doi.org/10.1007/s11573-018-0913-9