Using real option analysis for highly uncertain technology investments: The case of wind energy technology

Abstract

This study examines the feasibility of using a theoretical model and empirical analysis methods to value renewable energy (RE) investment from perspective of real option analysis (ROA). Based on use of a ROA approach, the RE value is evaluated with respect to its ability to conform to the main sensitivity analysis of RE investment, as well as an empirical method devised to value RE investment by using actual data. The economic intuitiveness underlying the decision-making process for RE investment is elucidated, while empirical analysis is performed to demonstrate the effectiveness of the options value embedded in current development planning in Taiwan for wind energy. In addition to revealing the advantages of RE development when considering real option, analytical results indicate that ROA is a highly effective means of quantifying how investment planning uncertainty (including managerial flexibility) influences RE development. Besides evaluating the value of current RE investment, this study demonstrates that results of the theoretical model, empirical analysis, and sensitivity analysis correlate well with each other. Restated, the value of developing RE increases when increasing the underlying price, time to maturity, risk-free rate, and volatility. Conversely, the value of developing RE decreases when increasing the exercise price.

Introduction

Accelerated growth in fossil energy consumption has diminished rapidly fossil energy reserves worldwide, intensifying stress on current reserves daily due to increased demand. Since the industrial revolution, traditional fossil energy has been explored and extracted in significant amounts, gradually leading to its depletion. Table 1 lists the global reserves and projected years of supply remaining for major fossil energies [1]. Meanwhile, owing to adverse environmental impact caused by application of traditional energies, e.g., climate change, global warming green-house effect, and environmental pollution, reducing dependence on traditional energy sources and mitigating related environmental damage is essential for human survival. Defined as sustainable and clean, renewable energy (RE) can potentially overcome the gradual depletion of traditional fossil energies and their adverse environmental impact, while simultaneously addressing energy sustainability, economic development, and environmental protection-related issues (3E, see Fig. 1). Consequently, advances in RE applications have accelerated in the recent decade [2]. Taiwan is a densely populated island limited natural resources. Energy Consumption Island wide has exploded over the past two decades, i.e.48.04 million kiloliters of oil equivalent (KLOE) in 1989 to 113.09 million KLOE in 2009, representing an average annual growth of 4.37%. Of that in 2009, 96.87% accounted for energy use, and non-energy uses consumed 3.13% [3]. Taiwan went from a supply of 52.88 million KLOE in 1989 to 138.06 million KLOE in 2009, i.e. an average annual growth of 4.92%. Of this total in 2009, indigenous energy contributed 0.63%, and imported energy accounted for 99.37%. Classified by energy, coal contributed 30.45% in 2009, oil constituted 51.82%, natural gas shared 8.62%, hydro energy provided 0.26%, nuclear energy provided 8.72%, solar and wind energy provided 0.06%, and solar thermal 0.08% [4].

Characterized as sustainable and clean, renewable energies can potentially overcome gradual depletion of fossil fuels and global warming caused by greenhouse gas emissions [5], [6]. Therefore, RE has received considerable attention, with related applications accelerated in recent years [7], [8]. To remove barriers to develop RE, the Taiwan Government legislated the “Renewable Energy Development Bill” on July 8, 2009 through a 6-year national plan [9]. According to the legislation, the government may implement measures such as the Feed-in Tariff (FIT) and demonstrations to stimulate the development of RE incentives. The legislation focuses on promoting an ambitious target of achieving approximately 6500–10,000 MW of energy from RE by 2025, which is equivalent to increasing the cumulatively installed capacity of Taiwan power supply from RE to exceed 15% [9]. Additionally, the nationwide power capacity of RE is forecasted to increase up to 10 GW over the next two decades. Hopefully, actively implementing this legislation can achieve the so-called triple-win goal, i.e. reduction in greenhouse gas emissions, enhancement in energy diversity, and promotion of the green energy sector. Unfortunately, as the end 2010, besides hydropower and biomass, Taiwan still lagged far behind its RE goals (Table 2). Clearly, RE development in Taiwan, in addition to relying on intensive governmental promotional efforts, also requires public–private sector collaboration if the 2025 targets are to be met nationwide. Success of this undertaking largely depends on governmental policy support and a relevant legal basis during the early developmental period [10], [11], [12], [13], [14], [15], [16], [17], [18]. Nevertheless, governmental subsidies are insufficient. Investment firms must ultimately adopt innovative utilization methods and technologies, capacity expansion to achieve economies of scale, and internalization of the external costs of energy use if they are to fill the cost gap between RE and NRE, thereby enabling RE to compete with NRE in open markets.

RE technology advances are constrained by high research and development (R&D) costs and difficulty of investment recovery, long and deferrable planning processes, high investment risks and uncertain returns, as well as the liberty of decision makers to invest freely. Policy makers can thus exert managerial flexibility to adjust policies appropriately, ensuring that RE development policies meet policy targets. The ability to use real option analysis (ROA) to assess the benefits of RE development policies allows us not only to quantify managerial flexibility neglected by conventional assessment methods, but also minimize the possibility of underestimating policy value. Hence, development policies may capitalize on the options concept to generate value derived from “waiting” in order to reduce uncertainty in policy planning [19]. Nevertheless, interested investors are often deterred from investing not only because of many critical technologies have failed to achieve breakthroughs, but also because of investment risks are difficult to assess, ultimately reducing cost effectiveness in power generation [20].

Therefore, based on ROA, this study evaluates the value of investment opportunities and verifies the sensitivity analysis, which shows the relationship between the value of developing RE and underlying assets, as well as other main option parameters. The rest of this paper is organized as follows. Section 2 provides a literature review. Section 3 describes the methodology of this study. Section 4 presents the parameter collection and empirical results. Conclusions are finally drawn in Section 5, along with recommendations for future research.