The use of real options approach in energy sector investments

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Abstract

Energy shortage, global warming, and climate change led to an increase in the use of alternative sources of energy, with renewable energy sources (RES) playing a fundamental role in this new energetic paradigm. However, the investment costs often constitute a major barrier to their spread use. Moreover, the overall benefits of renewable energy technologies are often not well understood and consequently they are often evaluated to be not as cost effective as traditional technologies. From the moment that the energy sector started a deregulation process, with a high level of competitiveness and associated increased market uncertainty, traditional project evaluation techniques alone became insufficient to properly deal with these additional risk and uncertainty factors. The diffusion of the renewable energy technologies is also affected by this feature. The way investors evaluate their investments call now for the use of more sophisticated evaluation techniques. Real options approach can deal with these issues and, as so, began to be considered and applied for the energy sector decision aid. This approach it is now extensively widespread in evaluating investment projects in the energy sector. A large set of applications in almost all fields of energy decision making, from electricity generation technologies appraisal to policy evaluation is available in the literature. However the use of this technique in the field of RES is still limited and worth to be analysed. This paper addresses this issue. A review of the current state of the art in the application of real options approach to investments in non-renewable energy sources and RES is presented, giving perspectives for further research in this field.

Introduction

The use of renewable energy sources (RES) emerges as a necessary condition to achieve sustainable development. Energy shortage, global warming, and climate change forced an increase in the use of alternative sources of energy. Nay, the world's economy is affected by the prices of the raw materials and is in turn affected by the constant instability of the fuel-based energy prices. For these reasons, RES have a fundamental role in providing universal access to energy, creating new business opportunities, reducing the external energy dependency and, at the same time, contributing to reduction of greenhouse gas emissions.

However, RES are not competitive when compared to other generation technologies. Partly, because of the fact of the investment costs often constitute a major barrier to their spread use [1]. Moreover, the overall benefits of renewable energy technologies are often not well understood and consequently they are often evaluated to be not as cost effective as traditional technologies. Consequently, in order to RES become competitive the ensuring of adequate support schemes is necessary encouraging investments in this field [2].

However, a good support scheme may not be enough to encourage investments. The increase of the generation capacity in a liberalized market, requires taking into account future uncertainties [3]. Traditional evaluation models relying mainly on discounted cash-flows fail to assess the strategic dimension of the investments and do not allow for properly dealing with the risk and uncertainty of these particular projects. The diffusion of the renewable energy technologies is also affected by this feature, so, the way investors evaluate their investments call for the use of more sophisticated evaluation techniques. Real options theory, gives the investor the ability to account for the value inherent in the flexibility to delay an irreversible investment into the future. In the RES projects field, this ability become particularly important, as these are often modular, normally require short construction times and exhibit learning curves with very steep slopes [4], [5].

The remainder of this paper is organized as follows. Section 2 gives an introduction of the basic principles of the real options theory. Section 3 presents a line of thought to real options valuing model. Section 4, firstly, provides a literature review on the application of the real options theory to non-renewable energy projects, to understand the importance and the applicability of this technique. Secondly, a literature review of the application of this technique to RES projects is presented. Section 5 concludes the paper presenting the main findings and some perspectives for further research.

Section snippets

Basic principles of real options theory

Wrong investment decisions today can lead to situations in the future that will be unsustainable and lead eventually to the bankruptcy of enterprises. Therefore, good financial management combined with good capital investment decision-making are critical to survival and long-term success of the firms [6].

Traditionally, the net present value (NPV) and discounted cash flow (DCF) methods are worldwide used to evaluate project investments [7], [8]. However given that, today investments are

Valuing real options

To introduce some valuing models it is important to select and describe the main variables that influence the value of real options. As mentioned earlier, an option has a value in a specified period of time. According to Copeland and Antikarov [14] this value depends, essentially on six variables. First, the value of the underlying asset, which in the case of real options is a project, investment or acquisition. If the value of the asset goes up, so does the value of the real option. Second,

Application of the real options theory to the energy sector

The energy sector, since 1970, has suffered market, regulatory and technological changes. In this new context traditional capital budgeting methods are no longer sufficient to properly evaluate investments in this sector. In fact, this sector has moved from a regulated and monopolistic sector to a deregulated, uncertain and highly competitive sector [27].

This change opened the way to the application of the real options theory. To illustrate the increased importance of the real options approach

Conclusion

An increase on the interest and application of the real options theory to the energy sector decision making has been noticed during the last years. As seen in the presented literature review, this theory has been used to all sectors in the energy, from generation to evaluation of policies. This increase reveals that the interested parties in the energy sector now understand the limitations of the traditional techniques, given the potential of the real options theory. The RES sector is no

Acknowledgments

This work was financed by: the QREN – Operational Programme for Competitiveness Factors, the European Union – European Regional Development Fund and National Funds- Portuguese Foundation for Science and Technology, under Project FCOMP-01-0124-FEDER-011377 and Project Pest-OE/EME/UI0252/2011.

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