Real Options Valuation of US Federal Renewable Energy Research, Development, Demonstration, and Deployment

Benefits analysis of US Federal government funded research, development, demonstration, and deployment (RD 3) programmes for renewable energy (RE) technology improvement typically employs a deterministic forecast of the cost and performance of renewable and non-renewable fuels. The benefits estimate for a programme derives from the difference between two forecasts, with and without the RD 3 in place. The deficiencies of the current approach are threefold: (1) it does not consider uncertainty in the cost of non-renewable energy (NRE), and the option or insurance value of deploying RE if and when NRE costs rise; (2) it does not consider the ability of the RD 3 manager to adjust the RD 3 effort to suit the evolving state of the world, and the option value of this flexibility; and (3) it does not consider the underlying technical risk associated with RD 3 , and the impact of that risk on the programme's optimal level of RD 3 effort. In this paper, a rudimentary approach to determining the option value of publicly funded RE RD 3 is developed. The approach seeks to tackle the first deficiency noted above by providing an estimate of the options benefit of an RE RD 3 programme in a future with uncertain NRE costs. While limited by severe assumptions, a computable lattice of options values reveals the economic intuition underlying the decision-making process. An illustrative example indicates how options expose both the insurance and timing values inherent in a simplified RE RD 3 programme that coarsely approximates the aggregation of current Federal RE RD 3. This paper also discusses the severe limitations of this initial approach, and identifies needed model improvements before the approach can adequately respond to the RE RD 3 analysis challenge.