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A Real Options Approach to Evaluating New Nuclear Power Plants

Geoffrey Rothwell

Year: 2006
Volume: Volume 27
Number: Number 1
DOI: 10.5547/ISSN0195-6574-EJ-Vol27-No1-3
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Abstract:
Although nuclear power plants are being built in Asia, they have not been ordered in the U.S. since the 1979 accident at Three Mile Island. For many reasons, new attention is being given to light water reactors. Currently- operating nuclear power plants in the U.S. were built under rate-of-return regulation. Now, new nuclear power plants must compete in power markets. This paper models the net present value of building an Advanced Boiling Water Reactor in Texas using a real options approach to determine the risk premium associated with net revenue uncertainty. It finds that a cost of about $1,200 per kilowatt-electric (including financing costs) for advanced light water nuclear power plants could trigger new orders. On the other hand, owner-operators might be willing to pay higher prices for nuclear megawatts if methods for mitigating price, cost, and capacity risk through contracts or real assets could be found.



Valuing Plug-In Hybrid Electric Vehicles' Battery Capacity Using a Real Options Framework

Derek M. Lemoine

Year: 2010
Volume: Volume 31
Number: Number 2
DOI: 10.5547/ISSN0195-6574-EJ-Vol31-No2-5
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Abstract:
Plug-in hybrid electric vehicles (PHEVs) enable their drivers to choose whether to use electricity or gasoline, but this fuel flexibility benefit requires the purchase of additional battery capacity relative to most other vehicles. We value the fuel flexibility of PHEVs by representing the purchase of the battery as the purchase of a strip of call options on the price of transportation. We use a Kalman filter to obtain maximum likelihood estimates for three gasoline price models applied to a U.S. municipal market. We find that using a real options approach instead of a discounted cash flow analysis does not raise the retail price at which the battery pays for itself by more than $50/kWh (or by more than 15%). A discounted cash flow approach often provides a good approximation for PHEV value in our application, but real options approaches to valuing PHEVs� battery capacity or role in climate policy may be crucial for other analyses.



Optimal Abandonment of EU Coal-fired Stations

Luis M. Abadie, José; M. Chamorro and Mikel González-Eguino

Year: 2011
Volume: Volume 32
Number: Number 3
DOI: 10.5547/ISSN0195-6574-EJ-Vol32-No3-7
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Abstract:
Coal-fired power plants face potential difficulties in a carbon constrained world. The traditional advantage of coal as a cheaper fuel may erode in the future if CO2 allowance prices increase. When would it be optimal to abandon a coal station and obtain its salvage value? We assess this question following the Real Options approach. We consider the case of a coal plant that operates in a deregulated electricity market where natural gas-fired plants are the marginal units. We assume specific stochastic processes for the fundamental uncertainties in our model: coal price, natural gas price, and emission allowance price. The underlying parameters are derived from actual futures markets. They are further used in a three-dimensional binomial lattice to assess the decision to abandon. We draw the optimal exercise boundary. Sensitivity analyses (regarding fuel prices, allowance price, volatilities, useful life, residual value, thermal efficiency, safety valves in carbon prices, time step) are also undertaken.



Managing a Portfolio of Real options: Sequential Exploration of Dependent Prospects

James L. Smith and Rex Thompson

Year: 2008
Volume: Volume 29
Number: Special Issue
DOI: 10.5547/ISSN0195-6574-EJ-Vol29-NoSI-4
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Abstract:
We consider the impact of sequential investment and active management on the value of a portfolio of real options. The options are assumed to be interdependent, in that exercise of any one is assumed to produce, in addition to some intrinsic value based on an underlying asset, further information regarding the values of other options based on related assets. We couch the problem in terms of oil exploration, where a discrete number of related geological prospects are available for drilling, and management's objective is to maximize the expected value of the combined exploration campaign. Management's task is complex because the expected value of the investment sequence depends on the order in which options are exercised. A basic conclusion is that, although dependence increases the variance of potential outcomes, it also increases the expected value of the embedded portfolio of options and magnifies the value of optimal management. Stochastic dynamic programming techniques may be used to establish the optimal sequence of investment. Given plausible restrictions on the information structure, however, we demonstrate that the optimal dynamic program can be identified and implemented by policies that are relatively simple to execute. In other words, we provide sufficient conditions for the optimality of intuitive decision rules, like biggest first, most likely first, or greatest intrinsic value first. We also develop exact analytic expressions for the implied value of the portfolio, which permits the value of active management to be assessed directly.



The Impact of Stochastic Extraction Cost on the Value of an Exhaustible Resource: An Application to the Alberta Oil Sands

Abdullah Almansour and Margaret Insley

Year: 2016
Volume: Volume 37
Number: Number 2
DOI: 10.5547/01956574.37.2.aalm
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Abstract:
The optimal management of a non-renewable resource extraction project is studied when input and output prices follow correlated stochastic processes. The decision problem is specified by two Bellman equations describing the project when it is currently operating or mothballed. Solutions are determined numerically using the Least Squares Monte Carlo methodology. The analysis is applied to an oil sands project which uses natural gas during extracting and upgrading. The paper takes into account the co-movement between crude oil and natural gas prices and proposes two price models: one incorporates a long-run link between the two while the other has no such link. Incorporating a long-run relationship between oil and natural gas prices has a significant effect on the value of the project and its optimal operation and reduces the sensitivity of the project to the natural gas price process.



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

Djerry C. Tandja M., Gabriel J. Power, and Josée Bastien

Year: 2018
Volume: Volume 39
Number: Number 5
DOI: 10.5547/01956574.39.5.dtan
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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



A Compound Real Option Approach for Determining the Optimal Investment Path for RPV-Storage Systems

Benjamin Hassi, Tomas Reyes, and Enzo Sauma

Year: 2022
Volume: Volume 43
Number: Number 3
DOI: 10.5547/01956574.43.3.bhas
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Abstract:
The use of residential Photovoltaic-Storage systems may produce large benefits to owners and has expanded rapidly in recent years. Nonetheless, large uncertainties regarding the profitability of these systems make it necessary to incorporate flexibilities in their economic evaluations. This paper offers a new method to evaluate the compound flexibility of both the option of delaying investments and the option of further expanding the capacity of solar photovoltaic modules and batteries during the investment horizon. Flexibility is modeled as a compound real option, whose value is computed using a novel method that we call Compound Least Squares Monte Carlo (CLSM). The model is applied to the investment decisions associated to a residential Photovoltaic-Storage system. Results suggest that investors should use the proposed CLSM method in the economic valuation of multi-stage projects, since considering only a single flexibility could promote sub-optimal decisions. Moreover, in our case study, we show that it is optimal to break the investment down into two steps or more in 36% of future scenarios, on average.



A Real Options Analysis of the Effects of Oil Price Uncertainty and Carbon Taxes on the Optimal Timing of Oil Field Decommissioning

Yakubu Abdul-Salam

Year: 2022
Volume: Volume 43
Number: Number 6
DOI: 10.5547/01956574.43.6.yabd
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Abstract:
We use a real options model to examine the effects of three important sources of oil price uncertainty on the optimal timing of oil field decommissioning. These are (1) the degree of oil price volatility, (2) the level of the long-run equilibrium oil price, and (3) the speed of reversion of oil prices to their long-run equilibrium. We find that lower levels of equilibrium oil prices and speed of reversion to equilibrium prices have the effect of fostering early decommissioning. Oil price volatility however has the opposite effect. Our findings provide valuable insights into how policymakers may identify windows of opportunity for policy interventions leading to (1) an acceleration of the drive towards sustainable energy transition; and/or (2) the maximisation of economic recovery (MER) from oil and gas resources. With regards the former, we show that the imposition of carbon taxes fosters early decommissioning to a significant extent. In the most unfavourable oil price environment and under an aggressive tax regime for example, decommissioning may occur at a very early period in oil field operations, owing to over 45% of oil reserves being uneconomic to produce. The results highlight the effectiveness of carbon taxes as policy lever in jurisdictions that seek accelerated decarbonisation, climate change mitigation and energy transition goals.



Debt and Optionality in U.S. LNG Export Projects

Peter R. Hartley and Kenneth B. Medlock III

Year: 2023
Volume: Volume 44
Number: Number 2
DOI: 10.5547/01956574.44.2.phar
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Abstract:
U.S. liquefied natural gas (LNG) export projects have substantially more spot trading of LNG than traditional projects. While this reduces the debt capacity of the projects, it allows project developers to better exploit many types of real options. Exploiting those options greatly increases the positive skewness of project cash flows. While the modal operating profits for a representative U.S. LNG export project are unlikely to cover fixed costs, interest and taxes at usual leverage ratios, the mean real equity return is likely to be positive. Some quarters could return extremely high profits. Understanding determinants of spot trading of LNG matters because increased spot trading will better integrate global natural gas markets.



Common Stock Returns around Farmout Announcements in the Oil and Gas Industry

Luiz Fernando Distadio, Andrew Ferguson, and Peter Lam

Year: 2023
Volume: Volume 44
Number: Number 4
DOI: 10.5547/01956574.44.4.ldis
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Abstract:
We examine market reactions to farmout agreements, a common form of strategic alliance undertaken by oil and gas explorers internationally. Using an Australian sample of 722 farmout agreements announced during the 1990–2016 period, we find that farmout announcements generate a positive cumulative average abnormal return of 3.60% for farmors and 1.90% for farminees over a 3-day event window. Cross-sectional analysis of farmors' event returns provides results consistent with the resource pooling hypotheses. We also find that farmors' announcement returns are sensitive to the underlying oil price volatility, consistent with the real options view of farmout arrangements.




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