Real Options versus Traditional Methods to assess Renewable Energy Projects

• Published in: Renewable energy Vol. 68; pp. 588 - 594
• Main Authors: Santos, Lúcia, Soares, Isabel, Mendes, Carla, Ferreira, Paula
• Format: Journal Article
• Language: English
• Published: Oxford Elsevier Ltd 01-08-2014; Elsevier
• Subjects: Applied sciences; Binomials; Energy; Energy gap; Exact sciences and technology; Financing; Flexibility; Investment; Investment analysis; Natural energy; Production methods; Real options; Renewable energy; Uncertainty; Energy; Real options; Investment analysis; Renewable energy; Investment
• ISSN: 0960-1481; 1879-0682
• DOI: 10.1016/j.renene.2014.01.038

Several methods can be employed to evaluate investment in energy production. On one hand, traditional methods (Net Present Value (NPV) or Internal Rate of Return (IRR), for example) ignore certain project characteristics that may influence its evaluation, such as irreversibility, uncertainty and management flexibility. Nevertheless, the Real Option Approach (ROA) has an advantage over the application of traditional methods, since the prior uncertainties are taken into account. Thus, the main objective of this study is to apply ROA to a case-study (mini-hydro plant) through the use of the binomial tree developed by Cox, Ross and Rubinstein in 1979. This study concludes that the value of ROA is higher than the value of NPV because the investor can get better information and uncertainty is reduced when he has the option to defer the investment. In addition to providing a deep analysis on the major gaps in energy investment evaluation, this work contributes to a better understanding of the usefulness of ROA.
•Real Option Analysis (ROA) gives flexibility to investor to redefine his strategy.•Net Present Value (NPV) underestimates the project value.•The value of ROA is higher than the value of NPV since uncertainty is reduced.