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Real Option Valuation in a Gollier/Weitzman World: The Effect of Long-Run Discount Rate Uncertainty

Abstract:
Large-scale investment projects face significant long-run uncertainty in interest rates. However, little is known about the effect of long-term discount rate uncertainty on capital investment real option values. This paper bridges the long-run discount rate uncertainty literature developed in climate change economics with the financial literature on interest rate models and real options. First, we derive an Ingersoll-Ross real option model under the assumption of a declining discount rate model (DDR) following Gollier and Weitzman, and show how optimal investment timing is affected. Second, we study the problem of an open oil field with an abandonment option. We find that, compared with DDR, standard models using constant or mean-reverting interest rates undervalue projects and their real options to wait or to abandon. Indeed, results under DDR are more consistent with recent evidence on corporate decision-making under incomplete preferences or ambiguity. The results have implications for both energy investment under uncertainty and climate finance. Keywords: Oil and gas investment, Capital budgeting, Real options, Interest rates, Declining discount rate, Long-run uncertainty

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Energy Specializations: Energy Modeling; Energy Investment and Finance – Public and Private Risks, Risk Management

JEL Codes: C50: Econometric Modeling: General, Q41: Energy: Demand and Supply; Prices, Q42: Alternative Energy Sources, Q54: Climate; Natural Disasters and Their Management; Global Warming, C53: Forecasting Models; Simulation Methods, D81: Criteria for Decision-Making under Risk and Uncertainty, Q31: Nonrenewable Resources and Conservation: Demand and Supply; Prices

Keywords: Oil and gas investment, Capital budgeting, Real options, Interest rates, Declining discount rate, Long-run uncertainty

DOI: 10.5547/01956574.39.5.dtan

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Published in Volume 39, Number 5 of the bi-monthly journal of the IAEE's Energy Economics Education Foundation.

 

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