How to Proceed with Competing Alternative Energy Technologies: a Real Options Analysis

Siddiqui, Afzal and Fleten, Stein-Erik (2008): How to Proceed with Competing Alternative Energy Technologies: a Real Options Analysis.

Abstract

Concerns with CO2 emissions are creating incentives for the development and deployment of energy technologies that do not use fossil fuels. Indeed, such technologies would provide tangible benefits in terms of avoided fossil-fuel costs, which are likely to increase as restrictions on CO2 emissions are imposed. However, there are a number of challenges that need to be overcome, and the current costs of developing new alternative energy technologies would be too high to be handled privately. We analyse how a government may proceed with a staged development of meeting electricity demand as fossil-fuel sources are being phased out. A large-scale, new alternative technology is one possibility, where one would start a major research and development programme as an intermediate step. Alternatively, the government could choose to deploy an existing renewable energy technology, and using the real options framework, we compare the two projects to provide policy implications on how one might proceed.

• Item Type: MPRA Paper
• Institution: Norwegian University of Science and Technology (NTNU)
• Language: English
• Keywords: Alternative energy technologies; CO2 emissions; environmental policy; real options
• Subjects: D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D81 - Criteria for Decision-Making under Risk and Uncertainty; Q - Agricultural and Natural Resource Economics ; Environmental and Ecological Economics > Q4 - Energy > Q42 - Alternative Energy Sources

References

K. Alfsen, G.S. Eskeland, and K. Linnerud. Technological change and the role of nonstate actors. In F. Biermann, P. Pattberg, and F. Zelli, editors, Global Climate Governance Post 2012: Architectures, Agency and Adaption. Cambridge University Press, Cambridge, UK, 2009.

G.A. Davis and B. Owens. Optimizing the level of renewable electric R&D expenditures using real options analysis. Energy Policy, 31(15):1589-1608, 2003.

J.P. Décamps, T. Mariotti, and S. Villeneuve. Irreversible investment in alternative projects. Economic Theory, 28(2):425-448, 2006.

A. Dixit. Choosing among alternative discrete investment projects under uncertainty. Economics Letters, 41:265-268, 1993.

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

S.-E. Fleten, K.M. Maribu, and I. Wangensteen. Optimal investment strategies in decentralized renewable power generation under uncertainty. Energy, 32(5):803-815, 2007.

N. Goetz, R.-U. Hritonenko and Y. Yatsenko. The optimal economic lifetime of vintage capital in the presence of operating costs, technological progress, and learning. Journal of Economic Dynamics and Control, 32(9):3032-3053, 2008.

C. Gollier, D. Proult, F. Thais, and G. Walgenwitz. Choice of nuclear power investments under price uncertainty: Valuing modularity. Energy Economics, 27(4):667-685, 2005.

IPCC. Climate change 2007: The physical science basis. In S. Solomon, D. Qin, M. Manning, Z. Chen, M. Marquis, K.B. Averyt, M. Tignor, and H.L. Miller, editors, Contribution of Working Group I to the Fourth Assessment Report of the Intergovernmental Panel on Climate Change. Cambridge University Press, Cambridge, UK, 2007.

ITER. What is ITER? http://www.iter.org, 2007. Cadarache, France.

K. Jensen and P. Warren. The use of options theory to value research in the service sector. R&D Management, 31(2):173-180, 2001.

S. Majd and R.S. Pindyck. The learning curve and optimal production under uncertainty. The RAND Journal of Economics, 20(3):331-343, 1989.

N. Malchow-Møller and B.J. Thorsen. Repeated real options: optimal investment behaviour and a good rule of thumb. Journal of Economic Dynamics and Control, 29(6):1025-1041, 2005.

A.S. Manne. Waiting for the breeder. The Review of Economic Studies, 41:47-65, 1974.

D.P. Newton and A.W. Pearson. Application of option pricing theory to R&D. R&D Management, 24(1):83-89, 1994.

R.S. Pindyck. Investments of uncertain cost. Journal of Financial Economics, 34(1):53-76, 1993.

K. Roberts and M.L. Weitzman. Funding criteria for research, development, and exploration projects. Econometrica, 49(5):1261-1288, 1981.

G. Rothwell. A real options approach to evaluating new nuclear power plants. The Energy Journal, 27 (1):37-53, 2006.

E.S. Schwartz. Valuing long term commodity assets. Financial Management, 27(1):57-66, 1998.

A. Siddiqui and H. Gupta. Transmission investment timing and sizing under uncertainty. Working paper, Department of Statistical Science, University College London, London, UK, 2007.