Tuesday, January 24, 2006

Real Options: A Complementary Tool to Make Better Operational and Capital Investment Decisions in Power Systems

Resumen en español abajo

For regulated utilities, the economic evaluation method most widely used was the well known called “minimum-revenue-requirements method”. Because the utility is regulated, the rate of return on any investment is determined based on the allowed regulated return on investment. That return varies according to the regulatory scheme under the utility operates, and can be typically a weighted average return on bonds, where interest return is based on bond ratings and the equity return allowed by the regulating commission. Therefore, the return to bond-holders, return on equity, depreciation, tax charges, and revenues can all be calculated. The alternative that provides the lowest revenue requirements is considered the best choice.

By other side, the economic evaluation methods used by a business enterprise in a free market system are markedly different. For a competitive business enterprise, the widely used economic evaluation method is called a “discounted cash-flow rate-of-return method” (DCF). In this method, all of the cash flows are examined for each alternative through the time horizon of the evaluation. For each alternative, the cash flows are discounted at several different present-worth rates. That discount rate which results in the future cash flows equaling the initial investment is called the “discounted cash-flow rate of return”. The project with the highest discounted cash-flow rate of return is considered the best choice. All projects that have a discounted cash-flow rate of return that exceeds the cost of money are worth-while projects.

Some years ago, the issues in generation planning were when and how much generation needed to be installed, as well as what kind of equipment it should be (i. e., coal, gas turbine, combined-cycle). Then, reliability analysis, production simulation, and investment cost analysis were integrated to address the issue of generation planning. Utility investment planning has always been carried out in an environment of uncertanty. Within limits, utility managers have dealt with uncertainty in the investment process. However, it is unnecessary to say what has changed today in the power industry to alter nearly all the assumptions concerning the utility planning; in short, the risk and uncertainty underlying the investment decision process have increased dramatically. For instance, before making the decision of building a new gas-fired power plant we could ask ourselves about these operational and long-term questions: How high should electricity prices be compared to gas prices, before I start building a new gas power plant? (See for instance in this blog Arbitrage at hubs.) Does it matter whether the plant is base load, running whatever the level of electricity and gas prices, or peak load, running only when electricity price is above the fuel cost? How does the opportunity to abandon the plant influence the decision to invest? How do greenhouse emission cost affect profitability?

DCF is mathematically and computationally simple but most importantly reduces financial and economic information about the investment to a single value for the ease of decision-making. Johnathan Mun in his paper ”Real Options and Monte Carlo Simulation versus Traditional Valuation in Layman’s Terms” lists some DCF advantages:
  • Clear, consistent decision criteria for all projects.
  • Some results regardless of risk preferences of investors.
  • Quantitative, decent level of precision and economically rational.
  • Not as vulnerable to accounting convetions (depreciation, inventory valuation, etc.)
  • Factors in the time value of money and basic risk structures.
  • Relatively simple, widely taught, widely accepted.
  • Simple to explain to management: "If benefits outweight the costs, do it!"

However, the fundamental flaw with DCF is that it does not incorporate the risk of uncertainty by treating future cash flows in a deterministic manner. In Table1 (page 7) of the above paper Mun depicts DCF disadvantages regarding assumption vs. reality:

Disadvantages of NPV or DCF: Assumption vs. Reality

NPV AssumptionRealities
Decisions are made now and cash flow streams are fixed for futureUncertainty and variability in future outcomes.Not all decisions are made today, as some may deferred to the future, when uncertainty resolves.
Once launched, all projects are passively managed.Projects are usually actively managed throughout the project life-cycle, including check-points, decision options, budget constraints etc.
Future free cash flow streams are all highly predicatable and deterministic.It may be difficult to estimate future cash flows as they are usually stochastic and risky in nature.
Project discount rate used is the opportunity cost of capital, which is proportional to non-diversifiable risk.There are multiple sources of business risk with different characteristics, and some are diversifiable across projects or time.
All risks are completely accounted for by the constant discount rate.Project risk can change during the course of time.
All factors that could affect the outcome of the project are reflected in NPV.Project complexity and so-called externalities make it difficult to quantify all factors in terms of incremental cash flows. Disrupted, unplanned outcomes can be significant and strategically important
Unknown, intangible or immesuarable factors are valued at zero.Many important benefits may be intangible assets or qualitative strategic positions.

To cope with uncertainty a technique borrowed from financial options theory, known as real options, can be used to develop estimates of future uncertainty in prices given their observed volatility. Since traditional valuation tools lack to account properly for flexibility (how we would respond to unfolding events in uncertain markets), real options approach may be better suited for situations where compound risks and managerial flexibility are likely to have a significant impact on operations and economic performance of the enterprise. Thus, real options methodologies are very suitable for projects in the energy business since such projects incorporate many of the features that set the basis for real options theory. Such features are among others:

  • Large sunk investment cost. (E.g.: Investment in a hydro power plant or transmission equipment cannot be retrieved.)
  • Production flexibility. (E.g.: The power plant could only be operated when prices make it profitable. )
  • Option to expand capacity. (E.g.: Already existing power plants can have possibilities to install new capacity.)
  • Existence of futures and other derivatives that serve as spanning assets that reveal important info about the value of the project.

Google Books Search provide us with a list of books on Real Options

This a goog book to download: Real Options in Practice Marion A. Brach. 2003.

To start with real options we can read the following lesson: "Identifying Real Options" by professor Campbell R. Harvey (Fuqua School of Business), and then, to pay a view to some of these articles:

“How Much Is Flexibility Worth?” Thomas E. Copeland and Philip T. Keenan, The McKinsey Quarterly, 1998, Number 2.

"Making Real Options Real," Copeland, Thomas E. and Philip T. Keenan, The McKinsey Quarterly, 1998 Number 3.

"Exploiting Uncertainty: The 'Real Options' Revolution in Decision-making," Coy, Peter, Business Week, June 7, 1999.

The classical article"The Pricing of Options and Corporate Liabilities" F. Black and M. Scholes, The Journal of Political Economy, vol. 81 (1973) pp.637-654

"Real options and interactions with financial flexibility - Topics in Real Options and Applications" by Lenos Trigeorgis (Financial Management; 9/22/1993).

"An Essay on Real Options" Gueorgui Kolev. CERGE-EI.

Schlumberger on Real Options in Oil and Gas

And finally, "Real Options in Petroleum" , the first website on Real Options (1995) created by Marco A.G. Dias at Pontifícia Universidade Católica do Rio de Janeiro. The site is dedicated to Real Options Approach to Investments in General and Especially in Petroleum Exploration and Production. A huge real options resource with spreadsheets, presentations, thematic sections, software. Its "Real Options Selected Links" page is probably the best set of references on real options we can find in the web.

Options-based approaches have been employed within the gas and oil industries for many years to account for the impact of price volatility and cost fluctuations. In the power industry, by studying the volatility of forward prices of electricity and key cost components (e.g. fuel costs), an estimate of the long-term uncertainty in profitability can be obtained. It is this impact on long-term profitability than can influence investment.

Despite its interest, the real options approach has achieved little acceptance by power investors to date, and its future is not clear. A 2002 survey of 205 Fortune 1,000 CFOs by Colorado State University professor Patricia Ryan showed that only 11.4% said they used it, compared with 85.1% for sensitivity analysis and 66.8% for scenario analysis. As for “basic” capital-budgeting tools, DCF topped the list at 96%. A bit more about the future of real options can be read in this article: "Will Real Options Take Root. Why companies have been slow to adopt the valuation technique" Edward Teach. CFO Magazine (July 01, 2003.)

However, we can find applications in the power industry such as South Bay Power Project on the Chula Vista bay (San Diego, California); and about the construction of liquefied natural gas facilities along the Pacific coast of the United States, we can read this interesting article "Off-shore natural gas supply project - A Real Options Case Study" by Ted Forsman, José Carlos García Franco y Robert Luenberger.(Energy Pulse. 5.27.2004)

Readers interested in knowing more about real options applications in the Power Industry can start with the following report "Modern Asset Pricing and Project Evaluation In the Energy Industry" by David G. Laughton, Jacob S. Sagi, and Michael R. Samis. September 2000.

An interesting list of reports on real options applications in the Power Industry follows below:

Modeling Investment Risks and Uncertainties with Real Options Approach. Ming Yang and William Blyth. February 2007. A Working Paper for an IEA Book: Climate Policy Uncertainty and Investment Risk

Power Generation Investment in Electricity Markets" OECD/IEA, 2003.

Impact of Climate Change Policy Uncertainty on Energy Sector Investments" William Blyth. March 2005. Chatham House.

"An Oligopolistic Investment Model of the Finnish Electricity Market" - Pierre-Olivier Pineau and Pauli Murto

"Electricity Derivative Markets: Investment Valuation, Production Planning and Hedging." Erkka Näsäkkälä. Helsinki University of Technology (Department of Engineering Physics and Mathematics - Systems Analysis Laboratory). May 2005.

"Real Option Analysis of Gas Fired Power Plants" Rolf Magnus Alstad and Jørgen Taule Foss. December 2003. NTNU (Norwegian University of Science and Technology.)

"Does the Black-Scholes formula work for electricity markets? A nonparametric approach." Erik Hjalmarsson. Department of Economics, Göteborg University and Yale University. Working Papers in Economics no 101, July 2003.

"A real options model for portfolio selection of oil and gas assets" Gabriel A. C. Lima and Saul B. Suslick, Institute of Geosciences and Center of Petroleum Studies. State University of Campinas - NICAMP. Copyright 2002, Society of Petroleum Engineers Inc.

“Valuation of Power Generation Assets: A Real Options Approach” Doug Gardner and Yiping Zhuang, 2000.

"Operational Planning Constrained by Financial Requirements” Guillermo Gutierrez-Alcaraz, Gerald B. Sheble, Electrical and Computer Engineering Dept., Iowa State University. Second Carnegie Mellon Conference in Electric Power Systems: Electricity Transmission in Deregulated Markets: Challenges, Opportunities, and Necessary R&D Agenda. December 2004.

"Real Option Models and Electricity Portfolio Management" Hlouskova, J; Kossmeier, S; Obersteiner, M; Schnabl, A. OSCOGEN. Discussion paper No. 9. May 2002.

"Valuation of Investment and Opportunity-to-Invest in Power Generation Assets with Spikes in Electricity Price" Shi-Jie Deng School of Industrial & Systems Engineering Georgia Institute of Technology.

"Incorporating Operational Characteristics and Startup Costs in Option-Based Valuation of Power Generation Capacity", Shi-Jie Deng School of Industrial Systems Engineering Georgia Institute of Technology, and Shmuel S. Oren, Industrial Engineering and Operations Research University of California at Berkeley. Probability in the Engineering and Informational Sciences (PEIS), 17 (2) (2003), pp.155-181.

“Power portfolio optimization and the importance of operational flexibility” Gustaf Unger, Hans-Jakob Luthiy, IFOR, ETH Zentrum, Swiss. December 13, 2002

"Towards a European Market of Electricity: Spot and Derivatives Trading" by Helyette Geman (University Paris IX Dauphine and ESSEC). May 2002.

Nuclear Power Applications

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. Real Options approach can be applied to evaulate investments in nuclear assets too. See for instance the article in the January 2006 issue of The Energy Journal 27 (1) pp.5-21, called "A Real Options Approach to Evaluating New Nuclear Power Plants,” by Geoffrey Rothwell, Associate Director of Public Policy Program under Stanford Institute for Economic Policy Research (SIEPR), and Senior Lecturer, Department of Economics at Stanford University, addressing how generating companies should evaluate the risks of investing in new nuclear power plants. 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. A previous paper of Dr. Rothwell on this matter is What Construction Cost Might Trigger New Nuclear Power Plant Orders? March 2004. SIEPR Policy paper No. 03-019.

Roques (2005)(*), Fabien A.; Nuttall(*), William J.; Newbery(*), David M. and de Neufville(**), Richard. Nuclear Power: A Hedge Against Uncertain Gas and Carbon Prices? Electricity Resarch Policy Group (University of Cambridge. U.K.), November 2005. (*) U. Cambridge, (**) US MIT.

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Opciones Reales: Una herramienta complementaria para perfeccionar las decisiones de inversión de capital y operación del sistema de potencia en el Sector Eléctrico

El método tradicionalmente empleado de determinación de los Ingresos Necesarios en el Sector Eléctrico para analizar la rentabilidad de una inversión pierde relevancia con la reforma del sector. El método clásico del Flujo de Caja Descontado empleado típicamente por las empresas que operan en mercados competitivos no contempla la incertidumbre de los precios de los combustibles intrínseca a los mercados eléctricos, ni otros riesgos a ellos asociados. La valoración de Opciones Reales es una metodología derivada de la teoría de las opciones finacieras que se emplea para tratar esta incertidumbre.

Algunos Links en español:

"Opciones reales en la valoración de proyectos de inversion" Juan Mascareñas. Universidad Complutense de Madrid. Version inicial Mayo 1999. Última revisión Julio 2004.

Valoración económica de inversiones en nueva capacidad de generación eléctrica. Análisis comparativo de metodologías Enrique Baranda Gonzalez. Poyecto fin de Carrera dirigido por Álvaro Baíllo Moreno. Escuela Técnica Superior de Ingeniería ICAI. Universidad Pontificia Comillas. Madrid. 2005.

"Valoración de las Opciones Reales" William Bailey, Benoît Couët, Ashish Bhandari, Soussan Faiz, Sundaram Srinivasam and Helen Weeds.Oilfield Review.

"Aplicación de Instrumentos Financieros en el Sector Eléctrico" José Luis Arriagada Carranza. Pontificia Universidad Católica de Chile. Escuela de Ingeniería. Departamento de Ingeniería Eléctrica. 2001.

”Determinación de Vatriables Estratégicas en el Precio Eléctrico. Análisis del Mercado español” Mariano González (Universidad San Pablo CEU), Sánchez y Ramón Comendador García (MICYT). Revista de Economía Industrial no 345 - 2002/III.

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At 8:42 PM, Blogger Geoffrey Rothwell said...

I'd like to post my articles in Public Utilities Fortnightly (May 2004) and The Energy Journal (Jan 2006) that apply a real options approach to evaluating new nuclear power plants. Until then you can email me, rothwell@stanford.edu


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