Economic Foundations of Energy Investments - Green Energy and Efficiency: An Economic Perspective - page 62

Section 3 analyzes the futures markets for energy commodities, the carbon market
and the 3:2:1 crack spread. Section 4 reviews the literature on numerical valuation
methods and provides a few examples. Section 5 concludes.

2 Real Options and Energy

This section describes the Real Option Approach for valuing investments in Real
Energy Assets under uncertainty.
Real options is an approach to capital budgeting that can perhaps be applied to
the valuation of energy investment far better than to other types of real assets,
because there are markets with quotes for contracts with long maturity dates. This
approach considers the options available to managers, such as choosing levels of
output, abandoning the plant and increasing or reducing capacity, though usually
only those options considered most signi cant for the analysis to be conducted are

taken into account.
Real options analysis (ROA) considers a problem of optimization under
uncertainty of a real asset given the available options and the technical and

nancial

constraints that may exist.
Risk originates from uncertainty, of which there are two types: Economic and
technical.
Economic uncertainty is correlated with the general movements of the economy.
The oil price, the carbon price and 3:2:1 crack spread 3 volatilities are examples of
economic uncertainty. Such uncertainty does not generally change when a company
exercises a real option, unless there is massive investment of the same type. In any
event, when futures market quotations are taken into account they are generally
assumed to be made with all the available information, and also to re ect the expected

future behavior of agents. Economic uncertainty is therefore considered to be
exogenous to the decision-making process. Increased uncertainty leads to incentives
to postpone investment (if that option is available) and a higher NPV is required for
investment to take place immediately. Changes in uncertainty through volatility
signi cantly change the expected yield required to justify immediate investment.

Sometimes the option to postpone investment may not exist or may be insigni cant,

because the timeframe of the concession for making the investment is very short or
because the investment may be made by a competitor, resulting in the

rm losing the
business opportunity. However, there are also highly interesting real options, such
as the option of choosing whether to produce or not depending on margins, choosing
the optimum production level or even choosing not to produce at all.

3 The crack spread measures the difference between the purchase price of crude oil and the selling
price of nished products. In the 3:2:1 crack spread for every three barrels of crude oil processed
by the re nery two barrels of gasoline and one barrel of distillate fuel are obtained.