Topic outline

  • Course description


    This course will cover the theory of real options. Examples and applications will emphasize energy economics. By considering discretion over investment timing and managerial flexibility (in terms of technology choice, capacity size, and operations), real options provides an enhanced analytical framework within which to make decisions given uncertainty in one or more underlying variables. Due to such features, it is an enhancement to the traditional now-or-never net present value (NPV) approach, which is unable to account for not only discretion over timing, but also sequential decision-making. Since many investment and operational problems in the energy sector are rather sensitive to uncertainty (e.g., in fuel prices and investment costs), technology choice, and sequencing of projects, they are readily amenable to analysis by the real options approach, which would allow for assessment of strategies that would not have been able to be addressed adequately otherwise. Thus, in this course, we will provide a thorough grounding in the theory of real options, which will also encompass topics from recent research papers, before proceeding to illustrate how it may be applied to relevant problems in the energy sector.

     

    Reading material

     

    Dixit, AK and RS Pindyck (1994), Investment under Uncertainty, Princeton University Press, Princeton, NJ, USA (ISBN:0-691-03410-9) (required)

     

    McDonald, RL (2006), Derivatives Markets, 2nd edition, Addison Wesley, Upper Saddle River, NJ, USA (ISBN:0-201-72960-1) (reference)

     

     

    Research Papers:

     

    1. Adkins, R and Paxson, D (2011), "Renewing Assets with Uncertain Revenues and Operating Costs," Journal of Financial and Quantitative Analysis 46, 785-813
    2. Bøckman, T, S-E Fleten, E Juliussen, HJ Langhammer, and I Revdal (2008), "Investment Timing and Optimal Capacity Choice for Small Hydropower Projects," European Journal of Operational Research 190(1): 255-267
    3. Chronopoulos, M, B De Reyck, and AS Siddiqui (2011), "Optimal Investment Under Operational Flexibility, Risk Aversion and Uncertainty," European Journal of Operational Research 213(1), 221-237
    4. Dangl, T (1999), "Investment and Capacity Choice under Uncertain Demand," European Journal of Operational Research 117(3): 1-14
    5. Décamps, JP, T Mariotti, and S Villeneuve (2006), "Irreversible Investment in Alternative Projects," Economic Theory 28(2): 425-448
    6. Dixit, AK (1993), "Choosing Among Alternative Discrete Investment Projects under Uncertainty," Economics Letters 41: 265-268
    7. Fleten, S-E, KM Maribu, and I Wangensteen (2007), "Optimal Investment Strategies in Decentralized Renewable Power Generation under Uncertainty," Energy 32(5): 803-815
    8. Gollier, C, D Proult, F Thais, and G Walgenwitz (2005), "Choice of Nuclear Power Investments under Price Uncertainty: Valuing Modularity," Energy Economics 27(4): 667-685
    9. Hugonnier, J and E Morellec (2007), "Real Options and Risk Aversion," working paper, HEC Lausanne, Lausanne, Switzerland
    10. Näsäkkälä, E and S-E Fleten (2005), "Flexibility and Technology Choice in Gas Fired Power Plant Investments," Review of Financial Economics 14(3-4): 371-393
    11. Pindyck, RS (2002), "Optimal Timing Problems in Environmental Economics," Journal of Economic Dynamics and Control 26: 1677-1697
    12. Rothwell, G (2006), "A Real Options Approach to Evaluating New Nuclear Power Plants," The Energy Journal 27(1): 37-53
    13. Siddiqui, AS and S-E Fleten (2010), "How to Proceed with Competing Alternative Energy Technologies: a Real Options Analysis," Energy Economics 32(4): 817-830
    14. Siddiqui, AS and KM Maribu (2009), "Investment and Upgrade in Distributed Generation under Uncertainty," Energy Economics 31(1): 25-37
    15. Siddiqui, AS and C Marnay (2008), "Distributed Generation Investment by a Microgrid under Uncertainty," Energy 33(12): 1729-1737
    16. Wickart, M and R Madlener (2007), "Optimal Technology Choice and Investment Timing: a Stochastic Model of Industrial Cogeneration vs. Heat-Only Production," Energy Economics 29: 934-952