Real Options And Investment Decision Making
Promoting choice and valuefor all gas and electricity customersReal Options and Investment Decision MakingConsultationReference:32/12Contact: James GrayburnPublication date:19 March 2012Team:RIIO-GD1Response deadline:1 June 2012Tel:020 7901 7483Email:james.grayburn@ofgem.gov.ukOverview:Real options analysis seeks to value flexibility in investment opportunities – both theflexibility offered to management once the investment is undertaken, and theflexibility of delaying the investment through time. The real options approachcontrasts with the standard approach to investment decision making, the net presentvalue (NPV) approach, which assumes the investment opportunity is a now-or-neverdecision, and once the investment is undertaken, there is no scope for managers toreact to new information and to change course.By ignoring the value of flexibility, the NPV framework has a bias towards projectswhich do not provide flexibility (e.g. large scale capital investments) relative to moreflexible options (e.g. interruptible contracts or demand-side options in the context ofenergy networks). In this paper, we identify the factors which lead to high realoption values, and the circumstances under which we should apply a real optionsframework. As we set out, a real options approach should help decision makingwhere the investment environment is characterised by uncertainty and managementflexibility in responding to investment needs.Ofgem/Ofgem E-Serve 9 Millbank, London SW1P 3GEwww.ofgem.gov.uk
Real Options and Investment Decision MakingContextAs part of our work in regulating energy markets, we undertake formal appraisals ofpotential policy options using cost benefit analysis. We set out the way weundertake cost benefit analysis in our Impact Assessment Guidance.1 In the contextof price-regulated companies, we also undertake appraisals of companies’ proposedinvestment decisions, and issue guidance to regulated companies on how toundertake investment appraisals where they are seeking funding from customers.This document describes a real options approach to undertaking policy or investmentappraisals, and how this contrasts with the standard net present value (NPV)approach. Following responses to this consultation, we will consider how weincorporate real options analysis within our policy and investment appraisal work.Associated documentsAssociated documentsReal options: An application to gas network interruptible contract auctions(supplementary annex) 32a/12 – link to documentReal options: An application to gas network interruptible contract auctions(supplementary excel model) 32b/12 – link to tterReg/IA/Pages/ImpactAssessments.aspx2
Real Options and Investment Decision MakingContents1. Introduction42. NPV and real options analysis5Why is a real options framework important?5What is a real option and what determines its value?6When does a real option approach to investment potentially provide a materiallydifferent answer to a NPV approach?8Why is real option analysis likely to be useful in the energy sector?9Conclusion123. Real options in energy networksIntroductionNetwork investment: an expansion optionNetwork investment: a deferral option131313154. Conclusions20Appendices21Appendix 1 - Consultation Response and Questions22Appendix 2 – Regulatory Precedent24IntroductionNew ZealandAustraliaAppendix 4 - Feedback Questionnaire242425263
Real Options and Investment Decision Making1. Introduction1.1. Discounted cash flow (DCF) or net present value (NPV) analysis is thestandard approach to investment decision making. However, the approach makessome limiting assumptions. Once the investment decision is taken, the NPVapproach assumes that there is no scope for managers to react to new information,although in practice many investments confer future options and managementflexibility. For example, over the life of an investment, decisions can be made toexpand, contract, or shut-down projects, and such flexibility may contributesignificantly to the value of the project. In addition, the NPV approach ignoresflexibility with regard to timing of an investment decision, i.e. the option to defer aproject or “wait-and-see”.1.2. The static nature of the NPV approach means that it systematicallyundervalues investment opportunities which provide future options. Under certaincircumstances, eg where there is significant uncertainty and flexibility, the NPVapproach can lead to poor policy and investment decisions. As we set out in thispaper, uncertainty and option flexibility characterise many investment decisions inthe energy sector.1.3. By contrast, real options analysis seeks to value flexibility - both the flexibilityembedded within the investment option, and the flexibility of delaying theinvestment through time. In this paper, we explain the difference between a NPVand real options approach to investment decision making. We also set out thefactors which lead to high real option values, and identify the circumstances wherewe should consider applying this framework.1.4. Finally, we also provide examples of the application of the real optionsanalysis in the energy sector, including a detailed application in relation tointerruptible contract auctions in the gas distribution sector drawing on analysisundertaken in the context of the current gas distribution price control review (RIIOGD1). As we set out in the supplementary annex to this paper, the proposedchanges require GDNs to consider the option value of associated with an interruptiblecontract (a deferral option) and should lead to an increase in the use of interruptiblecontracts to meet incremental capacity requirements.Structure of this paper1.5.This report is structured as follows:Section 2 provides an overview of real options analysis, and contrasts thiswith an NPV approach.Section 3 provides two potential applications of the real options approach inthe energy sector.Section 4 draws conclusions and sets out next steps.4
Real Options and Investment Decision Making2. NPV and real options analysisChapter SummaryIn this section we describe the real options approach to investment appraisal, andcontrast this with the standard discounted cash flow (DCF) or net present value(NPV) approach.Question 1: Do you agree or disagree that a real options approach is useful in thecontext of policy and investment appraisal in the energy sector? Please providereasons.Why is a real options framework important?2.1. The standard approach for evaluating investment opportunities is to usediscounted cash-flow (DCF) analysis or net present value (NPV) techniques.2 Thesimplest statement of the NPV decision rule is that you should discard all projectswith negative NPVs and undertake all projects with positive NPVs. Such a decisionrule ensures that companies maximise value for shareholders (or in the case ofpublic investment decisions, economic welfare).2.2. The NPV framework is the standard model for investment decision making;however, it is also subject to extensive criticism. Academics and practitionerscriticise the NPV framework for failing to value management flexibility associatedwith investment decisions.3 The NPV approach presupposes a static approach toinvestment decision-making – which ignores the possibility for management to reactto future events. The critics claim that over the life of an investment, decisions canbe made to expand, contract, or even shut-down the project investment, and theflexibility offered by such investments may contribute significantly to the value of theproject. However, the NPV framework systematically undervalues such flexibility,which can lead to managers making the wrong investment decision (i.e. one thatdoes not maximise economic welfare).2.3. The NPV framework also ignores flexibility with regard to the timing of theinvestment. Every project competes with itself delayed in time. For example, itmight be valuable to delay an investment decision to a future date when keydeterminants of the project’s value are known. By contrast, the NPV approach2See for example, Copeland, T., and Antikarov, V., (2002) Real Option, A practitioner’sguide, p.56.3This criticism has a long history. See for example: Trigeorgis, L. and Mason, Scott P(1987) Valuing Managerial Flexibility, Midland Corporate Finance Journal, 1987, 5 (1), pp.1421. For a more recent critique, see Copeland, T and Antikarov, V, (2002) op. cit., Chapter 4.5
Real Options and Investment Decision Makingassumes that the investment decision is a take-it-or-leave-it decision at that momentin time.2.4. Real options analysis seeks to value such flexibility - both the flexibilityembedded within the investment opportunity (eg expand, contract etc.), and theflexibility of delaying the investment through time.2.5. A common analogy used to describe the different approaches to investmentappraisal is the decision over a mode of transport to complete a journey. 4 Considerthe decision over whether to undertake a journey between London and Edinburgheither by car or by aeroplane. We might consider travelling by plane offers relativelylittle flexibility, in terms of responding to unexpected events such as adverseweather conditions and associated delays. Once the decision is made to travel byair, it is relatively difficult to change destination. By contrast, travelling by car offersthe flexibility to respond to traffic and weather conditions, e.g. by altering our routeor stopping-off on the way etc. NPV analysis weighs up the merits of the two optionsby assuming that we will always follow the standard route, regardless of anyunexpected events. That is, NPV analysis considers only the expected (or central)cost and journey times associated with the air and car options. By contrast, realoptions analysis uses the values associated with NPV (i.e. the expected cost andjourney time) but augments this with analysis of the value associated with theflexibility offered by travelling by car (e.g. the ability to change destination, abandonthe journey etc.)2.6. In summary, conventional static NPV analysis may undervalue projects bysuppressing the value of flexibility embedded within many options. As aconsequence, the NPV framework has a bias towards projects which do not provideflexibility (e.g. large scale capital investments) relative to more flexible options (e.g.demand-side options in the context of energy markets). There is evidence tosuggest that firms incorporate the value of real options within investment decisionmaking in a heuristic way, eg by applying a discount rate higher than the cost ofcapital.5 However, the real options framework provides a more objective approachto valuing flexibility and the optimal timing of investments.What is a real option and what determines its value?2.7. Formally, a real option is an option which arises in relation to a realinvestment decision, in which there is flexibility to take decisions in the light of4See for example, Copeland t., and Antikarov, V., (2002) op. cit., p.4; Boyle, et al(February 2006) op. cit. p.45For example, Dixit and Pindyck discuss the prevalent use by firms of hurdle rates inexcess of their cost of capital in investment decision-making, as well as decisions to stay inmarkets for lengthy periods where the firm is incurring operating losses. Such behaviourappears irrational, but can be explained by real option values and irreversibility ofinvestments. See Dixit, A, and Pindyck, R. (1994) Investment Under Uncertainty, pp 6 & 7.6
Real Options and Investment Decision Makingsubsequent information. Real option theory is concerned with valuing this flexibility,and determining the optimal timing of such investment decisions.62.8. Like a financial option, a real option is the right but not the obligation to takea pre-defined action, at a pre-determined cost called the exercise price, for apredetermined period of time – the life of the option. The actions concern deferral,expansion, contraction, abandonment etc. of a real investment decision. Theanalogous actions for financial options relate to the right to buy (a call option) or sell(a put option).2.9. Like financial options, the value of a real option depends on fivecharacteristics. Table 2.1 shows the characteristics of a real option that determineits value alongside the equivalent parameters for a financial (call) option.2.10. The first determinant of a real option value is the present value of a project’scash-flows (S). For financial options, this is known at the value of the “underlyingasset or stock”, on which the option is written. The second determinant of value isthe amount of money that needs to be invested if you are constructing an asset(with a call option) or the amount of money to be received if you are selling an asset(with a put option). For financial options, this is known as the exercise price of theoption (X).2.11. Along with a measure of the project’s systematic risk, these two parametersconstitute the NPV, i.e. equal to the present value of the investment’s cash-flows (S)relative to the investment cost (X) or (S-X).2.12. The two constituent elements of NPV analysis (S and X) are also central to areal options approach to investment appraisal. However, the real options analysisdraws on three further factors. The third determination of an option value is thetime elapsed until the option is no longer valid or time to expiration (t). The optionvalue increases the longer the time to expiration, as the option provides the abilityfor the decision-maker to react to new information over a longer-period of time. Afourth factor is the volatility of the returns to the investment or underlying riskyasset (σ). The value of an option increases with volatility as the option holderbenefits from upside risk, as the option can be exercised at a fixed price (at a profitof S-X) but the holder is protected from downside risk, as we can choose not toexercise (when S X). A fifth variable is the risk-free rate over the life of the option,which is used to discount future cash-flows.76International Encyclopedia of Business and Management (1996), Real Options, p.4255.Future cash-flows are valued using the risk-free rate and risk-adjusted probabilities.For a discussion of this approach, see Copeland, and Antikarov (2003) Real Options, APractitioner’s Guide, Chapter 5.77
Real Options and Investment Decision MakingTable 2.1: Determinants of real option values and financial (call) options8Real option parametersFinancial (call) optionparametersVariablePresent value of a project’s cashflowsStock priceSInvestment expenditureExercise priceXLength of time over which decisionmay be deferredTime to expirationtTime value of moneyRisk-free rate of returnrfRiskiness of project’s cash-flowsVariance of returns on stockσWhen does a real option approach to investment potentiallyprovide a materially different answer to a NPV approach?2.13. First, the investment needs to be partly irreversible (or sunk). If the cost ofinvestment is fully recoverable, then there is no value in waiting to obtain newinformation and hence no option value.2.14. Second, there must be a significant element of uncertainty, which is related toboth the volatility of the underlying asset and the time before we have to make adecision (e.g. exercise the option). The greater the uncertainty the greater the valueof managerial flexibility in responding to new information.2.15. Third, there must be investment opportunities which provide managementwith flexibility to respond to the new information. For example, real option analysisis valuable where we have the option to phase the investment (expansion options) orto delay the investment (a deferral option).2.16. Fourth, the investment decision should be relatively marginal, i.e. the smallerthe value of (S-X) the greater the option value. In other words, if the project NPV ishigh, then the option to invest (say) is always likely to be exercised and thecomponent of the project’s value which is represented by the option is relativelyminor. Conversely, if the NPV is extremely negative, no amount of optionality canrescue the project. Thus in the extreme cases (ie where S-X is very high or verylow), an options framework is unlikely to yield a different investment strategyrelative to the static NPV analysis.8See: Leuhrman, Timothy A. (1998) Harvard Business Review, July-August 1998,Investment Opportunities as Real Options: Getting Started on the Numbers8
Real Options and Investment Decision MakingWhy is real option analysis likely to be useful in the energysector?2.17. First, investment in the energy sector is often characterised by long-livedirreversible investments, for example, in relation to generation plant or networkinvestments. The irreversibility of these decisions means that there is significantvalue in getting such decisions right as the salvage value is low.2.18. Second, investment decisions in the energy sector frequently involve theconsideration of a range of investment opportunities with different embedded optionsor degrees of management flexibility. For example, in deciding how to meet anetwork capacity constraint, we might have the option of investing on the network(in long-lived irreversible assets), investing in more flexible generation, or makingconstraint payments (i.e. a contractual solution). Thus, there are often differentlevels of managerial flexibility associated with the investment opportunities whichNPV analysis fails to value.2.19. Third, the anticipated decarbonisation of the UK energy sector means thatthere is significant uncertainty surrounding the way energy will be produced,consumed and transported in the UK. The level of uncertainty means that there issignificant value to investment options which provide flexibility. We provide a briefoverview of the key areas of uncertainty in the UK energy sector below.Uncertainty in the energy sector2.20. The government’s carbon emission reduction target is expected to lead to asignificant change in the future electricity generation mix.9 However, the futuregeneration mix will depend on the resolution of a number of uncertainties. There aretechnological uncertainties, for example, in relation to the development and futurerole of carbon capture and storage (CCS). There are also significant costuncertainties, eg in relation to nuclear capital and decommissioning costs and futurefossil fuel prices. In addition to uncertainties in relation to the generation mix, thereis also additional uncertainty over future capacity requirements. For example, thereis uncertainty in relation to future electricity demand from other carbon intensivesectors (which might decarbonise) such as the transport sector, for example, throughthe adoption of electric vehicles.2.21. DECC’s has set out a number of illustrative pathways for energy use, includingelectricity generation, to achieve the government’s decarbonisation target. DECC’sanalysis highlights the uncertainty with regard to the future generation capacity andmix. Figure 2.1 sets out the reference case and two of DECC’s six scenarios orpathways. 10 For example, under the reference or base case, characterised by little9The UK has a commitment to reduce its greenhouse gas emissions by at least 80% by2050 relative to 1990 levels. Source: DECC (July 2010) 2050 Pathways Analysis, p 610Figure 2.1 sets out the reference case and two pathways defined as follows:“Pathway Alpha illustrates a pathway with largely balanced effort across all sectors, based9
Real Options and Investment Decision Makingor no action to reduce carbon emissions, future electricity generation is dominated byunabated thermal generation. By contrast, under pathway alpha there is nounabated thermal generation by 2045. Under this pathway, the dominant generationsources are non-thermal renewable, nuclear power, and renewable. Pathway beta ischaracterised by the absence of CCS.Figure 2.1: Electricity generation in 2050 under reference c
Real Options and Investment Decision Making 5 2. NPV and real options analysis Chapter Summary In this section we describe the real options approach to investment appraisal, and contrast this with the standard discounted cash flow (DCF) or net present value (NPV) approach.
(2001) suggested that there is a need for customized option valuation models to account for the specialties of real options, and novel approaches have indeed followed (see for example Datar & Mathews, 2004; Collan et al. 2009). 2.3 Real Options Analysis Real options analysis, or real options valuation, refers to the valuation of real investments as
the model, we hope to overcome the barriers that currently exist in applying real options analysis (ROA) to real estate development, and provide developers with a tool to help them better understand the rewards associated with real options. Real options analysis is an important topic in real estate due to the nature of the development environment.
Chapter 27 The Real Options Model of Land Value and Development Project Valuation Major references include*: J.Cox & M.Rubinstein, “Options Markets”, Prentice-Hall, 1985 L.Trigeorgis, “Real Options”, MIT Press, 1996 T.Arnold & T.Crack, “Option Pricing in the Real World: A Generalized Binomial Model with Applications to Real Options”, Dept of Finance, /p div class "b_factrow b_twofr" div class "b_vlist2col" ul li div strong File Size: /strong 571KB /div /li /ul ul li div strong Page Count: /strong 109 /div /li /ul /div /div /div
investment, industry of investment, year of investment and stage of investment. The parameter estimates show California as a location for investment is significantly different in scale, industry and stage of investment from other states. The investment bubble of 1999 and 2000 is found to have created different patterns
investment anaylsis and decision-making. Mercer's Investment Consulting business Mercer is a leading global provider of investment consulting services, and offers customized guidance at every stage of the investment decision, risk management and investment monitoring process. We have been dedicated to meeting the needs of clients for more
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applying real options to real-world problems, and has undertaken real options valuation projects for government and private organisations worldwide. At the Colorado School of Mines, he teaches a 15-week graduate-level course on real options applications in the mining and petroleum industries.
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