Evaluation of hydropower upgrade projects - a real options approach

Elverhøi, Morten and Fleten, Stein-Erik and Fuss, Sabine and Heggedal, Ane Marte and Szolgayova, Jana and Troland, Ole Christian (2010): Evaluation of hydropower upgrade projects - a real options approach.

Abstract

When evaluating whether to refurbish existing hydropower plants or invest in a new power plant, there are two important aspects to take into consideration. These are the capacity chosen for the production facilities and the timing of the investment. This paper presents an investment decision support framework for hydropower producers with production facilities due for restoration. The producer can choose between refurbishing existing power plants and investing in a new production facility. A real options framework is proposed to support the investment decision. Using a case from Norsk Hydro ASA, a Norwegian hydropower producer, we employ the framework to evaluate the investment opportunities. Our main contribution is an approach that combines hydropower scheduling and real options valuation, and the results from our analysis suggest feasible investment strategies for Norsk Hydro ASA.

• Item Type: MPRA Paper
• Language: English
• Keywords: Electricity price uncertainty; reservoir management; hydroelectric scheduling; investment under uncertainty; electricity markets
• Subjects: G - Financial Economics > G3 - Corporate Finance and Governance > G31 - Capital Budgeting ; Fixed Investment and Inventory Studies ; Capacity; G - Financial Economics > G1 - General Financial Markets > G13 - Contingent Pricing ; Futures Pricing; Q - Agricultural and Natural Resource Economics ; Environmental and Ecological Economics > Q4 - Energy

References

Bøckman, T., Fleten, S.-E., Juliussen, E., Langhammer, H., Revdal, I., 2008. Investment timing and optimal capacity choice for small hydropower projects. European Journal of Operational Research 190 (1), 255–267.

Botterud, A., 2003. Long-Term Planning in Restructured Power Systems: Dynamic Modelling of Investments in New Power Generation under Uncertainty. Ph.D. thesis, Norwegian University of Science and Technology.

Chorn, M., Shokhor, S., 2006. Real options for risk management in petroleum development investments. Energy Economics 28 (4), 489–505.

Dangl, T., Wirl, F., 2004. Investment under uncertainty: calculating the value function when the Bellman equation cannot be solved analytically. Journal of Economic Dynamics and Control 28, 1437–1460.

Dixit, A. K., Pindyck, R. S., 1994. Investment Under Uncertainty. Princeton University Press, Princeton, NJ.

EEX, 2008. European Energy Exchange AG. www.eex.com/en/, [8 June 2008].

EIA, 2009. Energy Information Administration. http://www.eia.doe.gov/, [6 April 2010].

Fleten, S.-E., Wallace, S. W., Ziemba, W. T., 2002. Hedging electricity portfolios using stochastic programming. In: Greengard, C., Ruszczynski, A. (Eds.), Decision Making under Uncertainty: Energy and Power.

Fuss, S., Szolgayova, J., Obersteiner, M., Gusti, M., 2008. Investment under market and climate policy uncertainty. Applied Energy 85, 708–721.

Johnsen, T. A., Verma, S. K., Wolfram, C. D., 1999. Zonal Pricing and Demand-Side Bidding in the Norwegian Electricity Market, University of California Energy Institute, POWER Working Paper-063.

Keppo, J., Näsäkkälä, E., 2008. Hydropower with Financial Information. Applied Mathematical Finance 15 (5), 1–27.

Kjærland, F., 2007. A real option analysis of investment in hydropower - The case of Norway. Energy Policy 35, 5901–5908.

Lucia, J. J., Schwartz, E. S., 2002. Electricity prices and power derivatives: Evidence from the Nordic Power Exchange. Review of Derivatives Research 5 (1), 5–50.

Nord Pool, 2008. Nord Pool ASA. www.nordpool.com/custom/Templates/gzIframe.aspx?id=1069, [ 29 May 2008].

Norsk Hydro, 1987. Opprustning og utvidelse av eldre vannkraftverk, Rjukan-prosjektet, internal report.

NVE (Ed.), 2006. Energy in Norway. The Norwegian Water Resources and Energy Directorate, Oslo, Norway. Statnett, 2004. Handelsinntekt og systemvirkninger, Report ID 295068.

Tipping, J., Read, E., 2010. Hybrid Bottom-up/Top-Down Modeling of Prices in Deregulated Wholesale Power Markets. In: Rebennak, S., Pardalos, P., Pereira, M., Iliadis, N., (Eds.), Handbook of Power Systems, Springer

Tseng, C., Barz, G., 2002. Short-Term Generation Asset Valuation: A Real Options Approach. Operations Research 50 (2), 297–310.

Wallace, S. W., Fleten, S.-E., 2003. Stochastic programming models in energy. In: Ruszczynski, A., Shapiro, A. (Eds.), Stochastic programming. Vol. 10 of Handbooks in Operations Research and Management Science. Elsevier Science, pp. 637–677.

Yeh,W., 1985. Reservoir Management and Operations Models: A State-of-the-Art Review.Water Resources Research 21 (12).

Zhao, G., Davison, M., 2009. Valuing hydrological forecasts for a pumped storage assisted hydro facility. Journal of Hydrology 373, 453–462.