Investments in combined cycle natural gas-fired systems: A real options analysis

Energy projects with extended life cycle and initial investments can be non-profitable under discount cash flow methods. Therefore, real options analysis has become relevant as a pricing technique for these types of projects, with private risks and high investment levels. Following this question, this study analyses different real options approaches to select the most adequate for making investment decisions in the energy sector. Combined cycle natural gas-fired plants constitute relevant generation assets that building decisions can mostly be studied by real options tools. Because traditional pricing approaches (e.g. net present value, internal rate of return, benefit-cost ratio) fail to take into account the worth of flexibility, conditions for creating significantly large options-based value can be found. Being unable to capture the value associated with the decision maker’s ability to dynamically react to changing market conditions, these assets constitute a fine example of asset flexibility which contributes to increasing its intrinsic value.Employing a real options approach that fails to capture the uncertainty of all the periods and proposes a process that determines directly the uncertainty associated with the first period, the paper study concludes that its use can be considered fair. However, it shows that long periods of operation and poor adhesion to the Geometric Brownian Motion by the project returns might call into question its use in the energy market. The values for option pricing have remained inside acceptable ranges but some shortfalls could be found. First, the study employs Monte-Carlo simulations which can be viewed as forward-looking processes and option pricing problems need backward recursive solutions. Second, the study demonstrates that its simplicity reaches results as accurate as those derived from approaches with additional complexity and computational requirements.

► The investment model considers two uncertain prices (electricity and natural gas).
► The model tests a more efficient way of considering the returns volatility.
► The Binomial option pricing model calculates the deferment option value.
► The returns volatility and the deferment option value turn the investment feasible.