A real options model to evaluate the effect of environmental policies on the oil sands rate of expansion

Canadian oil sands hold the third largest recognized oil deposit in the world. While the rapidly expanding oil sands industry in western Canada has driven economic growth, the extraction of the oil comes at a significant environmental cost. It is believed that the government policies have failed to keep up with the rapid oil sands expansion, creating serious challenges in managing the environmental impacts. This paper presents a practical, yet financially sound, real options model to evaluate the rate of oil sands expansion, under different environmental cost scenarios resulting from governmental policies, while accounting for oil price uncertainty and managerial flexibilities. Our model considers a multi-plant/multi-agent setting, in which labor costs increase for all agents and impact their optimal strategies, as new plants come online. Our results show that a stricter environmental cost scenario delays investment, but leads to a higher rate of expansion once investment begins. Once constructed, a plant is highly unlikely to shut down. Our model can be used by government policy makers, to gauge the impact of policy strategies on the oil sands expansion rate, and by oil companies, to evaluate expansion strategies based on assumptions regarding market and taxation costs.