Valuing uncertain cash flows from investments that enhance energy efficiency

There is a broad consensus that investments to enhance energy efficiency quickly pay for themselves in lower energy bills and spared emission allowances. However, investments that at first glance seem worthwhile usually are not undertaken. One of the plausible, non-excluding explanations is the numerous uncertainties that these investments face. This paper deals with the optimal time to invest in an energy efficiency enhancement at a facility already in place that consumes huge amounts of a fossil fuel (coal) and operates under carbon constraints.We follow the Real Options approach. Our model comprises three sources of uncertainty following different stochastic processes which allows for application in a broad range of settings. We assess the investment option by means of a three-dimensional binomial lattice. We compute the trigger investment cost, i.e., the threshold level below which immediate investment would be optimal. We analyze the major drivers of this decision thus aiming at the most promising policies in this regard.

► We quantitatively assess investments that enhance energy efficiency under uncertainty.
► Fuel price, allowance price, and investment cost are assumed stochastic.
► We develop a three-dimensional lattice approach to assess the investment option.
► Valuation rests on observed market prices (whenever possible).
► We undertake a sensitivity analysis with respect to the three sources of risk.