Estimating the Influence of Ethanol Policy on Plant Investment Decisions: A Real Options Analysis with Two Stochastic Variables

It is the Policy of Cornell University actively to support equality of educational and employment opportunity. No person shall be denied admission to any educational program or activity or be denied employment on the basis of any legally prohibited discrimination committed to the maintenance of affirmative action programs which will assure the continuation of such equality of opportunity. Abstract Ethanol policies have contributed to changes in the levels and the volatilities of revenues and costs facing ethanol firms. The implications of these policies for optimal investment behavior are investigated through an extension of the real options framework that allows for the consideration of volatility in both revenue and cost components, as well as the correlation between them. The effects of policy affecting plant revenues dominate the effects of those policies affecting production costs. In the absence of these policies, much of the recent expansionary periods would have not existed and market conditions in the late-1990s would have led to some plant closures. We also show that, regardless of plant size, national ethanol policy has narrowed the distance between the optimal entry and exit curves, implying a more narrow range of inactivity and a more volatile evolution for the industry than would have existed otherwise. Introduction Since 2005, the U.S. has witnessed a substantial increase in fuel ethanol production. This sizable growth has been due, at least in part, to the revision and/or creation of numerous federal, state, and local policies targeting both revenue enhancement and cost savings for ethanol producers (e.g., biofuels mandates, construction subsidies, tax credits, grants, loan guarantees). 2 Over the same time period, these policies, coupled with other market effects that increased the demand for corn (e.g., favorable exchange rates, increasing incomes in importing countries) and reduced expected supplies (e.g., weather-induced yield shocks), have contributed to record-high and more volatile market prices for agricultural and energy commodities.