Modeling Investment Risks and Uncertainties with Real Options Approach

Dr. Ming Yang is an energy and environment economist in the IEA, and Dr. William Blyth is a consultant. The views expressed in this Working Paper are those of the authors and do not necessarily represent the views or policy of the International Energy Agency or of its individual member countries. As this paper is a Work in Progress, designed to elicit comments and further debate, comments are welcome, directed to the author [email protected]. Abstract Changing energy price in competitive energy markets, uncertain future carbon price, uncertain government policy on climate change, and uncertain international regime on climate change mechanism all pose uncertainties to power sector investment. In a process of project investment evaluation, national governments and development banks traditionally use the methodology of discount cash flow (DCF). Unfortunately, this methodology cannot fully quantify these risks and uncertainties. Real Option Analysis (ROA) offers a nuanced approach to strategic investment that quantitatively takes into account investment risks and the value of the open options for budget decision-makers. The objective of this paper is to present a methodology and a computer model developed by the International Energy Agency (IEA) to quantify the impacts of climate change policy uncertainties on power investment using ROA approach. The methodologies include the traditional discounted cash flow approach to calculating project net present value, stochastic simulation to capture the characteristics of uncertain variables, and real options to capture investors' flexibility to optimize the timing of their investment. This paper presents details of the methodology framework, mathematics functions, database, and operation of the model. The results of this analysis are found in Blyth and Yang (2006) and will be included in a forthcoming book of the IEA (2007). Having been applied for case studies, the methodology and modeling have proven effective. This paper concludes that ROA could become a useful tool for the government policy makers and private investors to quantitatively analyze the impacts of climate change policy uncertainty and energy price uncertainty on energy sector investment. This paper describes the methodology and model used in an information paper of the IEA (Blyth and Yang, 2006) and a forthcoming book of the IEA (2007). The methodology and model will be used in future work investigating the implications of uncertainty for investment decisions. As a reference document, it has not been approved by any IEA committee. UK, and RWE npower for their voluntary contributions to this project. Absent such …