Investment timing and optimal capacity choice for small hydropower projects

Bøckman, Thor and Fleten, Stein-Erik and Juliussen, Erik and Langhammer, Håvard and Revdal, Ingemar (2006): Investment timing and optimal capacity choice for small hydropower projects.

Abstract

This paper presents a method for assessing small hydropower projects that are subject to uncertain electricity prices. We present a real options-based method with continuous scaling, and we find that there is a unique price limit for initiating the project. If the current electricity price is below this limit it is never optimal to invest, but above this limit investment is made according to the function for optimal size. The connection between the real option and the physical properties of a small hydropower plant is dealt with using a spreadsheet model that performs a technical simulation of the production in a plant, based on all the important choices for such a plant. The main results of the spreadsheet are simulated production size and the investment costs, which are in turn used for finding the value of the real option and the price limit. The method is illustrated on three different Norwegian small hydropower projects.

• Item Type: MPRA Paper
• Institution: Norwegian University of Science and Technology (NTNU)
• Language: English
• Keywords: OR in Energy; Real Options; Continuous Scaling; Project Evaluation; Hydropower
• Subjects: Q - Agricultural and Natural Resource Economics ; Environmental and Ecological Economics > Q2 - Renewable Resources and Conservation > Q25 - Water; Q - Agricultural and Natural Resource Economics ; Environmental and Ecological Economics > Q4 - Energy; G - Financial Economics > G1 - General Financial Markets > G13 - Contingent Pricing ; Futures Pricing

References

T. Dangl, Investment and capacity choice under uncertain demand, European Journal of Operational Research 117 (3)(1999), 415-428

J.-P. Décamps, T. Mariotti, S. Villeneuve. Irreversible investment in alternative projects, Economic Theory 28 (2006), 425–448.

M.A.G. Dias, K.M.C. Rocha, J.P. Teixeira, The optimal investment scale and timing: a real option approach to oilfield development. Pravap-14 Working Paper, Petrobras-PUC-Rio. November 2003.

A.K. Dixit, R.S. Pindyck, Investment under uncertainty, Princeton University Press, 1994

S-E. Fleten, K.M. Maribu, I. Wangensteen, Optimal investment strategies in renewable distributed generation under price uncertainty, Energy, Vol. 32, No. 5, 2007, pp. 803-815, 2007

S. Koekebakker, F. Ollmar, Forward curve dynamics in the Nordic electricity market, Managerial Finance 31 (6)(2005), 74-95.

J. Lucia, E.S. Schwartz, Electricity prices and power derivates – evidence from the Nordic power exchange, Review of Derivatives Research 5 (2002), 5-50.

R. McDonald, D. Siegel, The value of waiting to invest, The Quarterly Journal of Economics, 101 (4)(1986), 707-728.

NVE, Estimation of Potential for Small Hydropower in Norway – Assumptions, Methodology and Results, T. Jensen (ed), Norwegian Water Resources and Energy Directorate (NVE), Rep. 19, 2004

Pilipovic, D. Energy Risk: Valuing and Managing Energy Derivatives, McGraw-Hill, 1997

R.S. Pindyck The dynamics of commodity spot and futures markets: A primer, Energy Journal 22 (3)(2001)1-29

E.S. Schwartz, Valuing Long-Term Commodity Assets, Financial Management, 27 (1)(1998), 57-66

E.S. Schwartz, J.E Smith, Short-Term Variations and Long-Term Dynamics in Commodity Prices, Management Science, 46 (7)(2000), 893-911.

ESHA, State of the Art of Small Hydropower Situation in EU-25, European Small Hydropower Association (www.esha.be), 2005