Real options approach to renewable energy investments in Mongolia

Developing nations are seeking alternative energy for electricity, and one attractive alternative is renewable energy. This research analyzes changing investment environment for renewable energy with real options approach, and explores its potential in developing economies through studying the case of Mongolia under coal price uncertainty. To evaluate comparative attractiveness of either continuing to use coal-based infrastructures or switching to renewable energy, we formulate social revenue functions for the two environments, assuming that renewable energy has lower external costs, and coal prices follow geometric Brownian motion (GBM) or geometric mean-reverting (GMR) processes. We find the optimal trigger coal prices for switching technologies with some scenarios in electricity price and externality; characterize when renewable energy investments become attractive. In contrast to conventional wisdom, we identify some situations where the value of having more decision opportunities does not exceed that of a now-or-never decision for switching technologies, and welfare losses are incurred. The optimal trigger prices are higher in GBM than in GMR, and our result raises the possible risks for waiting to switch energy. To avoid welfare losses in Mongolia, the government should increase electricity prices or switch to renewable energy earlier, especially when people pay more for the removal of externalities.

► We examine energy switching from non-renewable to renewable one in Mongolia.
► We frame this problem as a type of real options and identify key determinants for it.
► Electricity price and externality valuation affect optimal investment decisions.
► A rise in both factors induces earlier switching to renewable energy.
► A series of implications obtained in this research applies to other general cases.