Case Study: Application of Real Options to Energy Investments

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Introduction
Energy investments have been evaluated using diverse methods. Santos et. al. (2014) argue that conventional approaches such as Net Present Value (NPV) or Internal Rate of Return (IRR) do not consider relevant project characteristics like irreversibility, uncertainty and management flexibility. They propose that the Real Options Approach (ROA) has an advantage over conventional methods. The aim of this essay is to apply real options to a renewable energy investment (mini-hydro plant) using the binomial lattice tree developed by Cox, Ross and Rubinstein.
Economic evaluation of energy investments
Electricity generation projects are more or less irreversible because their huge capital outlay cannot be easily diversified; the scientific basis for this proposition is provided by Pindyck (1991). Investors make decisions under high level of uncertainty associated with the market (Kumbaroglu et. al., 2008). Brach (2003) argues that the real options approach measures uncertainty and risk with flexibility. Santos et. al. (2014) propose that ROA considers the volatility associated with the evaluation process as a potential positive factor which adds value to the investment. Table 1 represents methods of assessment used in energy investment projects.
Table 1: Assessment Methods used in Energy Investment Projects

Source: Santos et. al., (2014)


The Real Options Approach for Evaluating Energy Investment
Prior to analysing the application of real options to energy…