Power Plant Investment in a Liberalized Market: A Real Options Approach for Sequential Investment Decision-Making

 

Project duration: 5/2009 - 11/2009

  Real options value depending on the risk level (standard deviation of the rate of return) and the risk-free interest rate (Source: Madlener and Stovernik, 2010) Real options value depending on the risk level (standard deviation of the rate of return) and the risk-free interest rate (Source: Madlener and Stovernik, 2010)

In this research project we study the economic feasibility of constructing a 560 MW coal-fired power plant in Turkey, using real options theory (Dixit and Pindyck, 1994). We start from a review of the Turkish electricity market as well as the literature on real options theory and power plant investment. We then investigate the peculiarities and uncertainties related to large-scale power generation capacities. Our special research focus is on the determination of the real options value of the power plant project considered. We develop a sequential investment model based on the binomial tree model by Cox, Ross and Rubinstein (1979). The four stages considered are (1) Planning; (2) Negotiation of Engineering, Procurement and Construction (EPC) contract; (3) Preliminary Notice to Proceed (PNTP); and (4) Notice to Proceed (NTP).

Applications of the real options approach for investment planning in the electricity sector have only in recent years started to penetrate the literature. Real options analysis has been adopted from the finance literature. It questions the underlying assumptions of traditional investment calculations based on the discounted cash flows, and seeks gains from deferring an irreversible investment expenditure that arise from better information about uncertain values (‘value of waiting’), if such a postponement is feasible. Multi-period evaluation of such an investment problem leads to a model formulation that can be solved recursively. Specifically, within such a dynamic framework one can systematically compare the expected net present values from immediate investment and from waiting to invest.

The Figure shows the outcome of varying the standard deviation in combination with varying the risk-free interest rate between 5% and 10%. If the risk-free interest rate rises, the option value rises as well, since for the achievable monetary advantage it becomes advantageous to postpone the investment. This only applies, however, under the assumption that the present value of the base object is independent on the risk-free interest rate. If we consider that for the project considered this value is determined by a present value calculation, which depends crucially on the risk-free interest rate, a countervailing effect can be observed. The Figure shows that the standard deviation’s influence on the level of the option value of the project considered here decreases with a rising risk-free interest rate.

We find that the option value is considerable, for instance due to various options of power supply contracting, which confirms the usefulness of the approach adopted compared to conventional discounted cash flow investment models which are unable to account for the flexibility in investment timing.

Project publications

Madlener R., Stoverink S. (2010). Power Plant Investments in the Turkish Electricity Sector: A Real Options Approach Taking into Account Market Liberalization, FCN Working Paper No. 21/2010, Institute for Future Energy Consumer Needs and Behavior, RWTH Aachen University, December (revised July 2011).

Madlener R., Stoverink S.(2012). Power Plant Investments in the Turkish Electricity Sector: A Real Options Approach Taking into Account Market Liberalization, Applied Energy, 97: 124-134.

Supervised student research

Stoverink S. (2009). Kraftwerksinvestitionen im türkischen Strommarkt – Ein Realoptionsansatz unter Berücksichtigung der Marktliberalisierung, Diploma Thesis, Chair of Energy Economics and Management, RWTH Aachen University, September.

Contact

Reinhard Madlener

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Reinhard Madlener

Institutsleiter FCN

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+49 241 80 49820

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