Economic Foundations of Energy Investments - Green Energy and Efficiency: An Economic Perspective - page 61

Financial economics-based methods: these draw on option pricing and portfolio
analysis. They provide a number of tools for dealing consistently and transpar-
ently with both time and uncertainty. When irreversibility considerations come to
the fore, as they do in projects involving renewables, management

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exibility
becomes particularly valuable, and the need for enhanced valuation methods
(over and above the standard Net Present Value (NPV)) is even greater. Such
methods include the ROA, which is analyzed here. Fernandes et al. [ 11 ] review
the use of the real option approach in the energy sector.

Emergy analysis: the net value of an environmental product or service to human
society does not stem from market forces; rather, it is determined by all the
available energy used (directly and indirectly) in the work process that generates
that product or service (expressed in units of a type of energy, in most cases
solar). Emergy analysis thus assesses a number of inputs that are usually
neglected by conventional economic valuation, and the thermo-dynamics-based
measures adopted go well beyond

￿

nancial prices. See for example Buller et al.

[ 6 ], and Brown and Ulgiati [ 5 ].

￿ Economic but non-welfare-based methods: these rely heavily on cost estimates.

For example, renewable energy resources are valued indirectly through the
replacement cost of nonrenewable ones. Similarly, renewables do not give rise
to the same external costs as nonrenewables; therefore the (saving in) abatement
cost or damage cost is used as a proxy for the implicit value of renewables. See
Georgakellos [ 13 ] and Richards [ 23 ], among others. However, these methods
assume a more deterministic style than those above, and ignore managerial and
strategic options that may appear in the future.

Graham and Harvey [ 15 , 16 ] use a survey answered by 392 CEOs to analyze the
practice of corporate nance with its different ways of valuing investment projects.

Their results show that the internal rate of return (IRR) and the NPV were the most
widely used methods, but that 26.59 % always or almost always used Real Option
Methods. The main valuation techniques used were IRR, NPV, the hurdle rate, the
payback period, sensitivity analysis, the earning multiple approach, the discounted
payback period and Real Option Analysis (ROA). In general, simpler methods such
as the payback period tended to be more prevalent at smaller rms. The evidence

con rms that Small and Medium Enterprises (SMEs) in the US manufacturing

sector use payback time and investment costs as the main determining factors in
deciding whether to invest in energy ef ciency, as shown by Abadie et al. [ 2 ].

cant effect on investment, as do other factors such as
liquidity constraints, lack of access to markets, ratings (credit risk), bureaucratic
obstacles, etc. In many cases, these factors hit SMEs particularly hard.
This chapter describes the foundations of and techniques for valuation under
uncertainty as applied to energy assets when there are complete markets on which
risks can be managed. To that end, it includes stochastic models of the performance
of energy commodities accompanied by illustrative examples.
The rest of this chapter is structured as follows: Sect. 2 examines real options,
emphasizing the

Uncertainty has a signi

nancial characteristics of the prices of energy commodities.