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Int. J. Shipping and Transport Logistics, Vol. X, No.

Y, xxxx 1
Copyright ©200x Inderscience Enterprises Ltd.











A real option application to investment in low-sulphur
maritime transport
Michele Acciaro
DNV Research and Innovation,
Det Norske Veritas, Veritasveien 1,
1363 Høvik, Norway
and
Center for Maritime Economics and Logistics/Erasmus SmartPort,
Erasmus University Rotterdam,
Burg. Oudlaan 50, 3062 PA, Rotterdam, The Netherlands
and
Department of Logistics,
The Kühne Logistics University,
Brooktorkai 20, 20457 Hamburg, Germany
E-mail: Michele.Acciaro@the-KLU.org
Abstract: In the last few years, sulphur emissions to air from shipping have
been of heightened interest to policymakers and the media, and more stringent
regulation is on the way. Various alternatives are available in the shipping
industry to comply with emission regulation and minimise impacts on
shipowners’ bottom-line. New regulation is adding complexity to managerial
decision-making, so that advanced decision support tools can provide useful
contributions to management processes. The present paper presents an analysis
of the options available to shipowners taking into consideration the value of
deferring the investment decision vis-à-vis the advantages obtainable fromthe
exploitation of fuel price differentials. The model shows that there is a trade-off
between low LNG prices and LNG capital expenses. While in most cases it
would not be recommended to invest in LNG as early as today, the model
shows that investment in LNG can make economic sense as early as 2015. This
is highly dependent on the capital costs necessary for retrofitting ships with
LNG engines and the difference between LNG prices and distillates prices.
Keywords: green shipping; sulphur emissions; real options; LNG retrofit; SO
x

regulation; maritime fuel prices; option to defer; maritime scrubbers; emission
control areas; ECAs; low-sulphur shipping.
Reference to this paper should be made as follows: Acciaro, M. (xxxx) ‘A real
option application to investment in low-sulphur maritime transport’, Int. J.
Shipping and Transport Logistics, Vol. X, No. Y, pp.000–000.
Biographical notes: Michele Acciaro is an Assistant Professor of Maritime
Logistics at Kühne Logistics University (KLU) – Wissenschaftliche
Hochschule für Logistik und Unternehmensführung. Until December 2012, he
held the position of Senior Researcher – Green Shipping at the Research and
Innovation Department of Det Norske Veritas AS (DNV) in Høvik, near Oslo.
Between 2004 and 2010, he worked as a Deputy Director and Researcher at the
Center for Maritime Economics and Logistics (MEL)/Erasmus SmartPort of
Erasmus University Rotterdam, with which he is still associated. He holds a
BSc and an MSc (cumlaude) in Statistics and Economics from the University
of Rome ‘La Sapienza’; an MSc in Maritime Economics and Logistics from









2 M. Acciaro












Erasmus University Rotterdam for which he was awarded the NOL/APL Prize
for Student Excellence; and a PhD in Logistics also fromErasmus University
Rotterdam. He was awarded the Young Researcher Best Paper Prize at the
IAME Annual Conference in Cyprus in 2005.
This paper is a revised and expanded version of a paper entitled ‘A real option
approach to investment in low sulphur maritime transport’ presented at the
World Conference on Transport Research Society Special Interest Group 2
(Ports and Maritime) Conference, Antwerp, May 2012.

1 Introduction
In the last few years, emissions to air from shipping have been of heightened interest to
policymakers and the media. The International Maritime Organisation (IMO), nation
states and regional governments, are increasingly issuing stringent regulation aiming at
curbing sulphur and nitrogen oxide emissions from shipping, and an intense debate is
taking place with reference to greenhouse gas emissions. In particular, the development
of sulphur regulation is likely to affect the geography of maritime transport as we know
it, providing the incentive for the implementation of new, more energy efficient
technologies and the use of greener fuels.
Sulphur emissions from shipping have an impact on the environment, human health
and climate (e.g., Eyring et al., 2010; Endresen et al., 2008; Buhaug et al., 2009). As far
as the local environment is concerned, effects have been well-known since the 1970s
(Knabe, 1976). Sulphur dioxide and nitrogen oxides are the major precursors of acid rain,
which has acidified soils, lakes and streams, accelerated corrosion of buildings and
monuments, and reduced visibility (World Bank, 2000). Sulphur oxides have been
identified as contributors to several health conditions in humans due to exposure to
sulphur dioxide, sulphate aerosols, and sulphur dioxide adsorbed onto particulate matter
(World Bank, 2000; Winebrake et al., 2009; Pope et al., 2004). Sulphur dioxide is also a
major precursor of fine particulate soot, which poses a significant health threat
(Barfknecht, 1983; Pope et al., 2004; Dockery, 2009). The noxious effects on human
health of sulphur emissions from shipping are also well established (Winebrake et al.,
2009; Corbett et al., 2007; Corbett and Fischbeck, 1997; Fuglestvedt et al., 2009). These
studies have triggered a regulatory response aiming at reducing sulphur emissions at a
local (e.g., California CARB programmes), regional (e.g., the EU Sulphur Directive) and
global level (e.g., MARPOL Annex VI).
As far as climate is concerned, the effects of shipping emissions are more complex,
since climate is impacted on directly by the release of long lived greenhouse gases such
as CO
2
and indirectly by the interactions of greenhouse gases such as methane and ozone
with nitrogen oxides (or NO
x
) emitted from ships, as well as through direct and indirect
aerosol effects, mainly due to shipping sulphur oxides (SO
x
) emissions. Several studies
have made estimates on the ship emissions impact on climate for one or more
components (Capaldo et al., 1999; Endresen et al., 2003, 2008; Eyring et al., 2007, 2010;
Lee et al., 2007; Lauer et al., 2007; Dalsøren et al., 2007; Fuglestvedt et al., 2008;
Berntsen and Fuglestvedt, 2008; Skeie et al., 2009; Olivié et al., 2012). The uncertainties
reported are large, in particular for indirect effects. However, it is notable that for
shipping, in contrast to, for instance aircrafts (Sausen et al., 2005), the overall effect of









A real option application to investment in low-sulphur maritime transport 3












emissions is a relatively strong cooling of the atmosphere (Fuglestvedt et al., 2009;
Laurer et al., 2009) mostly as a result of cloud formation and interaction with other
atmospheric particles
1
. These cooling effects though are relatively short-lived, while the
warming effects of carbon dioxide is likely to impact the Earth climate for centuries
(Laurer et al., 2009).
Sulphur emissions in shipping are directly linked to the quality of fuel used. Marine
fuels are divided between fuel oil and distillates. The first refers to residual fuel oil
manufactured at the bottom end of the oil refining process and it is often referred to as
heavy fuel oil (HFO). On average the sulphur content of HFO is 2.7% by mass (or m/m),
far above the average content of diesel or petrol
2
(Butt, 2007). Given its low cost
3
, HFO
is still the most commonly used type of fuel (Endresen et al., 2003). Sulphur emissions
are proportional to the fuel sulphur content and, therefore, current regulation has focused
on setting progressively more stringent standards on sulphur contents [IMO Resolution
MEPC.176(58) and EU Directive 2005/33/EC] although the regulator has allowed for
alternative measures, i.e., emission after treatment by means of exhaust gas cleaning
systems (EGCS). This implies that shipowners will need to run operations on low-sulphur
fuels or invest in emission cleaning devices. Since distillates are considerably more
expensive than HFO (Notteboom, 2011), most analyses have focused on the cost impacts
of regulation (Wang et al., 2007a, 2007b; Notteboom, 2011; Delft et al., 2006; Psaraftis
and Kontovas, 2009, 2010; Kontovas and Psaraftis, 2009; Bosch et al., 2009; NERA
Economic Consulting, 2005).
The adoption of the sulphur regulation is likely to be a game changer, as standards
will become more stringent in the near future. Various alternatives are available in the
shipping industry to comply with emission regulation and minimise the impact on
shipowners’ bottom-line. They are essentially either the switch to another cleaner fuel
(such as LNG, distillates, or biofuels) or the installation of exhaust gas treatment systems
(such as scrubbers or selective catalytic reduction). Nonetheless, new regulation is adding
managerial complexity, and advanced decision support tools can thus provide useful
contributions to management decision processes both for new-build or retrofits. The
selection of the right compliance strategy is made more elusive by the technical,
operational and economic uncertainty, associated, for example, with the use of alternative
fuels, such as LNG, and by the interaction with upcoming restrictions for carbon dioxide
and nitrogen oxides emissions.
In the various transportation industries, companies have opted for an environmentally
proactive attitude towards emission reduction, not only to comply with regulation, but
also in the attempt to avail themselves of the cost reduction benefits deriving from a more
efficient fleet and of the positive effects of green marketing (Huang and Rust, 2011;
Peattie and Crane, 2005). In shipping, even more than in logistics, financial
considerations are still the most important criterion to justify large investments (Acciaro,
2011; Young et al., 2010; Flatters and Willmott, 2009; Pickett-Backer and Ozaki, 2008),
although there is increasing recognition that sustainability can be a main driver for
innovation (Acciaro, 2011; Nidumolu et al., 2009).
In addition, even when environmentally proactive strategies are energy efficient and
can in principle benefit the company bottom-line, they are not necessarily implemented
easily if reliant on new technologies. New technologies are characterised often by high
levels of uncertainty and shipowners are cautious in committing their companies’ future
to unproven technologies. Even relatively well-established energy efficiency and fuel
saving technologies, might not be implemented as rapidly as it would be expected, due to









4 M. Acciaro












what is often referred to as the energy efficiency gap (Acciaro et al., 2012; J ohnson and
Andersson, 2011; J ohnson et al., 2012).
The uncertainty associated with new technologies and the importance that
environmental compliance will play in the future call for increased investment flexibility.
The importance of flexibility in operations is well established in shipping and logistics
(Lagoudis et al., 2010). Existing decision support tools, however, are often based on
discounted cash flow (DCF) techniques and are not always able to account for important
strategic issues such as the ability to change or defer an investment following altered
framework conditions internal or external to the company. DCF methods cannot account,
for example, for the costs associated with being locked in a (yet unproven) technology.
An alternative is offered by real option analysis (ROA), extensive accounts of which
are given in Brach (2003) and Trigeorgis (2002). ROA techniques have been employed
successfully also to model a number of strategic alternatives in the shipping industry.
Alizadeh and Nomikos (2009) provide various examples of the application of real options
to shipping specific problems. The first formalisation has been proposed by Dixit (as
cited in Alizadeh and Nomikos, 2009) where decisions to lay up vessels are modelled
through a ROA. The same technique was used then to evaluate the decision to enter and
exit the market (Dixit, 1989). Various studies made use of ROA to model other strategic
decision problems related to shipping investment and operations, such as the option to
extend a time charter agreement (Bjerksund and Ekern, 1995); the option to invest in a
new service (Bendall and Stent, 2001); the option to switch between dry and wet markets
for a combined carrier (Sødal et al., 2008) or for a shipping investor (Sødal et al., 2009);
investment in new vessels or portfolio of vessels (Hopp and Tsolakis, 2004; Bendall and
Stent, 2003, 2005, 2007; Dikos, 2008); the option to change the flag of a vessel
(Kavussanons and Tsekrekos, 2011).
The use of the option to defer has been mentioned in the shipping literature [Alizadeh
and Nomikos, (2009), p.462; Hopp and Tsolakis, (2004)]. In their book, Alizadeh and
Nomikos do not work out in detail the option of deferring the fixing of the ship in case of
momentary supply-demand imbalances. Hopp and Tsolakis (2004) present and advance a
case involving investment in a bulk vessel. Few models have been used to assess the
benefits of investment in environmental management (Yang, 2012), but no reference is
made in the shipping literature to the use of ROA for investment decision support in the
case of environmental compliance. Smaller investments, such as equipment or
retrofitting, allow for a simplification of the analysis and use of ‘vanilla’ call options,
since the capital costs can be estimated with more precision than in the case of purchase
of a vessel.
This paper applies ROA to model compliance with environmental regulation in
shipping. The uncertainty relative to the availability and price of alternative fuels
(specifically LNG) and the high CapEx of some of the available compliance solutions,
may significantly delay investment decisions, therefore contributing to the slow uptake of
fuel saving technologies today. Since some of this uncertainty might be resolved in the
future, the paper models the problem of compliance with sulphur regulation as an option
to defer.
The paper is structured in the following way. In this introduction, the problems
associated with low-sulphur shipping are described and the recent literature that has
emerged on the application of ROA in shipping is outlined. The next section describes
the regulatory framework and the main alternatives that are available for compliance.
Section three presents the ROA model, discusses the main results of the ROA and









A real option application to investment in low-sulphur maritime transport 5












provides a sensitivity analysis to changes in CapEx and maritime fuel price differentials.
Section four concludes.
2 Low suplhur shipping
2.1 Sulphur emission regulation
Gridded regional inventories for sulphur emissions, often referred to as SO
x
emissions,
are available already from the 1990s (Benkovitz et al., 1996) but it is only in the last
decade that regulation on sulphur emissions has materialised at an international level.
MARPOL
4
Annex VI regulates SO
x
emissions globally and regionally through a limit on
the sulphur content of the fuel burned aboard ships. EGCS are considered an equivalent
measure and can be used as an alternative
5
. Any other technological method that is
verifiable and enforceable to limit SO
x
emissions shall be approved by the national
maritime administration in accordance with IMO guidelines. Regulation 14 (in force
since 19 May 2005) prescribes that the limit on sulphur content in fuel for maritime use
worldwide today should not be higher than 3.5% by mass (also indicated as m/m), and
not higher than 0.5% m/m from the 1st of J anuary 2020, pending a revision in 2018
mostly focussing on issues related to fuel availability. Following the outcome of the
review the standard might be enforced by 1 J anuary 2025 instead of 2020.
The IMO also has provisions for specifically defined emission control areas (ECAs).
In these areas, emission limits are more stringent. Currently, the IMO has defined three
ECAs: the Baltic Sea Area, the North Sea and English Channel and since 2012, the USA
and Canada. ECAs need to be proposed by a country or group of countries and in case of
agreement within the Maritime Environmental Protection Committee (MEPC) of the
IMO become enforceable. At the moment, no further plans for new ECAs are on the
table, although there have been talks of designating the Mediterranean, Singapore, J apan
and Australia as future ECAs. For ships operating within an ECA
6
, the sulphur content on
fuel used on board of ships shall not exceed today 1.00% m/m and 0.10% m/m from the
1st J anuary 2015.
The consequence for a shipowner is that low and high sulphur fuels need to be stored
in different tanks. Those ships using separate fuel oils to comply with the SO
x
emission in
the ECAs must carry a written procedure showing how fuel oil changeover is performed.
The volume of low-sulphur fuel in each tank as well as the date, time and position of the
ship when any fuel oil changeover operation is completed prior to entry into an ECA or
commenced after exit from such an area, are recorded in a log-book prescribed by the
IMO.
Several countries have already implemented specific requirements as far as operations
in port and territorial waters are concerned. Most notable in this respect are the efforts of
the European Union, which with Directive 1999/32/EC25 sanctioned the reduction in the
sulphur content of certain liquid fuels and has set the first sulphur limits for marine
distillate oil used in EU territorial waters. Analogous efforts have been undertaken in the
United States, with the development of emission restrictions in Californian waters and
incentive schemes in several of the main ports for almost a decade. In Sweden specific
fuel provisions regulate emissions also on fairways.









6 M. Acciaro












2.2 Technical and operational alternatives
In view of the development of the regulatory mechanisms, shipowners have essentially
three strategies available to comply with sulphur regulation
7
:
• switch to distillate fuels
• use of a exhaust gas emission cleaning system
• switch to LNG.
We proceed now to discuss each of these strategies individually. It should be noted that
many of the measures aiming at a reduction of CO
2
emissions in shipping, such as speed
reduction, the use of biofuels, or new technologies, are also likely to reduce sulphur
emissions. It is beyond the scope of this paper, however, to discuss such measures, a
thorough analysis of which is provided elsewhere (e.g., Skjølsvik et al., 2000; Buhaug et
al., 2009; Eide et al., 2009, 2011; UNEP, 2011; Hoffmann et al., 2012).
2.2.1 Switch to distillate fuels
Shipowners aiming at complying with SO
x
regulation can switch to low-sulphur fuels.
Marine gas oil (MGO) and marine diesel oil (MDO), commonly referred as distillates,
are available with low-sulphur contents. From a technical point of view their use requires
minor modifications to the fuel system on board of the ship. One of the main issues with
this strategy is linked to the price of low-sulphur fuels and their availability.
Data relevant for the application of our model include the costs associated with the
use of distillate fuels that account for the different calorific values of the fuels. The main
issue with the use of distillate fuels is related to their price differentials with HFO and
with LNG. So far the prices of distillates and HFO have shown high correlations. If,
however, sulphur regulation changes demand patterns dramatically, a decoupling of the
price of distillates from the price of HFO is likely.
The problem of lack of available low-sulphur fuels is not new (Pappos and Skjølsvik,
2002). The market for low-sulphur fuel for maritime use is connected with other
transportation markets since demand for low-sulphur fuel in one market impacts the
availability of the same fuel in other markets. The gradual shift triggered by regulation in
inland transport in the late nineties increased the ratio of high-sulphur fuels to
low-sulphur fuels available for maritime use. The current and upcoming efforts to limit
SO
x
emissions in the world seas and in the ECAs will likely impact distillate prices also,
if refinery capacity will not be expanded
8
. Alternative options for the delivery of
low-sulphur fuels are limited essentially to re-blending, switching to lower sulphur crude
diets or invest in residue desulphurisation (RDS). These are all unattractive solution for
the refinery business
9
.
2.2.2 Use of a maritime EGCS
An EGCS, also referred to as scrubber, is a device that can be installed in order to
remove sulphur from the engine exhaust gas using different chemical processes. EGCS
are generally very large installations and require significant alterations aboard such as
tanks, pipes, pumps and wash water treatments. The sulphur rich sludge that is produced
by EGCS is categorised as special waste and requires special handling. From an









A real option application to investment in low-sulphur maritime transport 7












operational point of view, an EGCS increases fuel consumption a few percentage points
and thus slightly increases CO
2
emissions. Testing and operational experience with the
use of EGCSs on board of vessels is also limited. Several types of EGCSs are available at
the moment in the market
10
.
2.2.3 Switch to LNG
LNG has become a more popular fuel for maritime use in the last few years. This
development has gone hand in hand with the creation of a distribution network and, in
general, of the transport and availability of natural gas in LNG form. LNG availability is
very different from country to country and although the number of ships using LNG has
been increasing, LNG engines are far from being as common as diesel engines
11
.
Furthermore, the use of LNG requires a set of modifications for the vessel including
tanks and specific type of engines. This at the moment comes with substantial CapEx
(Æsøy et al., 2011).
Among the benefits of natural gas is the fact that it does not require any cleaning of
emissions to comply with SO
x
regulation and has low emissions of NO
x
and particles
12
.
As far as CO
2
is concerned, LNG is a fossil fuel and as such its impact on CO
2
emission
reduction is limited
13
. In the USA and in the proximity of large natural gas hubs, one of
the main advantages of LNG is its lower price with respect to oil-based distillates. Large
differences can be observed, however, among countries, since a global LNG market does
not exist and distribution costs can still be substantial. LNG prices are likely to benefit
from the availability of cheap natural gas resulting from the exploitation of
unconventional gas resources. The influence of such resources on the LNG market is,
however, largely unknown, because of the uncertainty connected, on the one side, with
the market response to their exploitation and, on the other side, with the environmental
impacts of the extraction and distribution processes (Howarth et al., 2011).
LNG appears to be economically viable for coastal and inland vessels, and even more
so in the ECAs (Verbeek et al., 2011; Pitt et al., 2010). Applications also to the ferry
markets appear promising (Banawan et al., 2010; Einang and Haavik, 2000).
Nonetheless, even in these cases, availability and distribution costs will remain important
in the next decade.
3 Real option analysis
3.1 ROA and DCF analysis
ROA is the application of financial options, decision science, corporate finance and
statistics to evaluating real or physical assets as opposed to financial ones. ROA makes
use of option theory to provide a better insight into the consequences of managerial
decisions. One of the main differences of ROA with respect to DCF analysis is a better
account of flexibility in managerial decisions. The capital budgeting method looks at
single projects by determining the future cash flows the project will generate and
discounting them at project specific discount rates. Risk is measured indirectly since the
discount rate is the opportunity cost of capital. Project appraisal techniques based on the
capital budgeting method assume that the firm embarks on a rigid and inflexible









8 M. Acciaro












investment path and ignores that the risk pattern of the project will change over time as
the project progresses.
ROA is ideal for the shipping industry since many investment decisions in shipping
are characterised by large CapEx and uncertain revenue stream or costs. In DCF analysis,
decisions are made now and the cash flow streams are fixed for the future. Projects are
not considered in their relations to the firm and once launched they are passively
managed. These characteristics do not fit well with the real investment practices in the
shipping industry, where uncertainty and variability in future outcome often require
delays in taking decisions. Furthermore sometimes maritime related projects cannot be
evaluated as stand-alone (network, synergies, regulation etc.) and are usually actively
managed through the life cycle of the investment, by modifying the fleet profile by sale
ad purchase, or scrapping some of the vessels, or delaying or cancelling delivery of new
vessels.
In the present case, we evaluate alternative investment strategies to comply with
upcoming SO
x
regulation in shipping. As outlined before, shipowners have three main
alternatives at their disposal: switching to low-sulphur fuels, investing in an EGCS or
retrofitting their engine for burning LNG. In the analysis, we focus primarily on the case
of LNG retrofit and use fuel switch as the base line. The fuel switch is in fact the only
option that would allow a shipowner to operate if they do not opt for investment in EGCS
or retrofitting (another option would be to cease operation, but we exclude this alternative
from the analysis). The decision to invest can be formalised as an option to defer, since
the decision on which alternative to invest can be postponed until more information,
specifically on the differential between LNG prices and fuel oil, is available. The option
to defer derives its value from reducing uncertainty by delaying an investment decision
until more information has arrived.
3.2 The option to defer
A shipowner today has the option to invest in LNG retrofit, keep on running on HFO and
then switch to distillates or invest in a scrubber and keep on using HFO. The shipowner is
not required to invest today either in LNG retrofit or scrubbers. If he invests in LNG he
will not have to worry about compliance with SO
x
regulation or NO
x
upcoming
regulation. The benefits of investing today are that he can directly reap the savings of
running on LNG and have a longer time to offset investment. If he invests in a scrubber
today fuel savings are not achieved, since he could operate with HFO without using the
scrubber, so to invest today in a scrubber is a strictly dominated strategy (i.e., a strategy
whose pay-offs are never higher than the pay-offs of other strategies).
In 2015, the shipowner will still have the option of investing in LNG, run on MDO or
invest in an EGSC. With the requirements of MARPOL becoming more stringent,
shipowners will have to either switch fuels or make new investments. In 2017, the
shipowner will have more information on the way the markets are developing specifically
on what the energy prices will look like and can still decide to invest in LNG or run on
MDO or use an EGSC.
We run the model for a Handysize vessel, that we assume to be in operation for
240 days a year and that it is required to comply with ECA sulphur emission regulation at
all times. In other words, we assume that the vessel behaves as if it is sailing only within
an ECA. For comparison purposes, we performed also some calculations on a larger
vessel (an Aframax), although such vessels do not sail generally exclusively within ECAs









A real option application to investment in low-sulphur maritime transport 9












and, therefore, the value of the case is only illustrative. Table 1 below summarises the set
of strategies available to shipowners, while Table 2, summarises the hypotheses used.
Table 1 Shipowners alternative SO
x
regulation compliance strategies
Today 2015 2017 Case
Invest in LNG No investment needed L1
Invest in EGCS No investment needed S1
Invest in LNG No investment needed L2
Invest in EGCS No investment needed S2
Invest in LNG L3
Invest in EGCS S3
Defer investment and run
on HFO
Defer investment and run
on distillates
Do not invest Base line
We assume that the costs for LNG and the EGCS are given as exogenous and are
obtained using a DCF model, manufacturers data and installation experience. This is an
adaptation of the model used by Eide et al. (2011). We also assume that the total costs
that the shipowner will incur are related to fuel prices and the shipowner will opt for
LNG if oil prices with respect to LNG prices are high. What matters in the analysis is
how much can the shipowner save by switching to LNG. In order to describe this issue,
the model accounts for differentials between fuel oil and LNG for maritime use
(corrected for differences in calorific values) from 0 (no difference) to 90% (LNG prices
are a tenth of distillate prices). We run the analysis considering an economic life for the
vessel up to 2020 (7 years) and to 2030 (17 years). For fuel prices, we use projections
elaborated in Acciaro (2012), that build on data from the International Energy Agency
(IEA) and the US Energy Information Administration (EIA) and we assume that prices
are modelled along four scenarios all equally probable. A low energy price, a high energy
price and two intermediate cases, one with low energy prices for the next four years and
high prices in the future, and an opposite case with high energy prices for the next four
years and low prices in the future.
Table 2 Vessel data specifications
Ship Unit Ship 1 Ship 2
Size Handysize Aframax
DWT Tons 35,000 115,000
GT Tons 25,000 62,000
Engine MAN 6S50ME-B9 127 rpm MAN 6S60MC-C
Power kw 8,000 12,240
Fuel consumption Tonnes 6,162 10,187
Cost of EGCS US$ 2,147,500 2,633,000
EGCS OpEx US$ 57,300 63,200
Cost of LNG retrofit US$ 18,000,000 26,000,000
Days at sea Days 240 240
Engine load % 80% 80 %
The basis of the calculations for the ROA is a spread-sheet-based cost model developed
by DNV to provide decision support to shipowners on ECA related investments. It builds
on the data and functionalities of previously developed models (Hoffmann et al., 2010;









10 M. Acciaro












Eide et al., 2009, 2011; Longva, 2010), which focused on CO
2
emissions and abatement
measures. The current cost model enables making cost analysis on sulphur and nitrogen
oxides reduction strategies and technologies. In particular, the model builds on large data
inputs and, on the basis of user-provided selection criteria, offers a detailed picture of the
economic benefits and disadvantages of the selection of one or more SO
x
(and NO
x
as
well as CO
2
) reduction strategies.
3.3 Model description
The objective of the model is to provide the price of the option as well as the value of the
deferral option. The first step in determining the value of the option is the calculation of
the value of investing now. In our case, this is the present value of the savings made
possible by the investment in LNG or EGCS as a result of the utilisation of a cheaper
fuel. Following the approach described in Brach (2003), the present value of this amount,
which is obtained from the difference between the various investment strategies and the
base line case, is calculated for the various fuel scenarios and for different LNG
differentials.
For each differential then the option price is calculated as:
max min
(1 )
max 0; (1 )
(1 )
t
c
t
p V p V
C K r
r
⎛ ⎞ + −
= − +
⎜ ⎟
+
⎝ ⎠
i i
i
where K is the investment cost today, r is the risk free rate, r
c
is the opportunity cost of
capital, t is the time period at which the option can be exercised, V
max
is the value to be
obtained in the best case scenario, V
min
, the value achieved in the worst case scenario and
p is the risk free probability, defined as:
min
max min
( )
e
r V V
p
V V

=

i

where V
e
is the expected asset value. By comparing the option prices, we can rank the
various options.
The option price formula can be used to calculate the trade-off between the LNG
differential and the capital expenses K. We can calculate K* as the value of K that for
each LNG price differential ensures that the option price is different from 0. We can
determine then in which cases the option is in the money, or in other words, in which
cases there is value in exercising the option. Exercising the option implies, in our case,
that the base line strategy or running on distillates is a strictly dominated strategy. The
highest value of K* that allows for the option to be still in the money can be calculated
as:
( )
*
(1 ) (1 )
e
t t
c
r V
K
r r
=
+ +
i
i

If management defers the investment for two or four years, it will have a much better
understanding of the fuel market and, therefore, be able to make a better-informed
decision on whether LNG is a substantially lower alternative to comply with SO
x

regulation. If indeed high-energy prices have materialised, making any fuel saving
reduction more important, then management will be better able to quantify the benefits of









A real option application to investment in low-sulphur maritime transport 11












LNG. In case of those strategies that allow for investment deferral, we have the
possibility of calculating the revenues in the worst and the best-case scenarios, and the
savings that can be gained or foregone in the various scenarios. For each scenario, we can
determine the highest pay-off between investing and not investing, inclusive of the
opportunity cost of capital. The pay-offs for all scenarios, can then be used to calculate
the risk free probability p and the option price as:
max min
(1 )
(1 )
t
p V p V
C
r
+ −
=
+
i i

It should be noted that the pay-off values include in this case also the value of capital and
the opportunity cost of capital. If we call C
q
the option price of investing in year q, where
C
0
denotes the option price of investing today, and calculate the revenue foregone (RF)
by delaying the investment decision (RF), i.e., the savings that could have been made if
the investment was performed today, we can consider:
0 q q
C C RF = −
and find for every LNG differential the value of K that equates the option of investing
now and investing in q years. This helps define the decision line between the two
strategies of investing or deferring. On the decision line the value of deferring is zero, so
that we can define the price of the deferral option of q years as D
q
:
0 q q q
D C RF C = − −
3.4 ROA results
3.4.1 Option values
Figure 1 below shows the different values for each investment strategy calculated for
various fuel price differentials. The results are given for a vessel with 7 years remaining
economic life (REL) and 17 years REL. For the first type of vessel, the option of
investing in LNG today is never in the money, indicating that it is better to use the base-
line strategy, i.e., switch to distillate fuels. Deferred LNG investment appears to be the
most valuable strategy, always above EGCS. We observe that the value of the deferred
investment strategy decreases as the differential between LNG and distillates increases.
In fact, a higher differential makes it less worth to wait to invest, but yet, with the
parameters used in this case, it is still the highest-value strategy
14
.
For a newer vessel (17 years REL) we would expect that investing in LNG now is a
more attractive strategy than for vessels with a shorter REL. This is the case but only for
high differences between LNG prices and distillates above 60%. The option value of
investing in LNG now remains still below the price of the deferral strategies. A comment
should be made by the movement of the price curves for deferred investment in 2 and
4 years. We observe that while in general the longer deferral period for investment in
LNG has a higher value, the option values converge for high price differentials. This is
because the savings obtainable over the last 10 years of economic life of the vessel are
dominant and are not dependent on whether the investment is made in 2017 or 2015.
Note that since EGCS savings are not modelled as a function of LNG prices, the value of









12 M. Acciaro












the option remains unchanged as the difference between distillate and LNG prices
increases.
Figure 1 Option values (y-axis), Handysize vessel (see online version for colours)

Figure 2 Option value (on the y-axis), Aframax vessel (see online version for colours)

Figure 2 shows the option value of the same investment strategies for a larger vessel.
CapEx for LNG retrofit are higher and so is fuel consumption. This explains why the
option values are in general higher. Because of the higher savings and of the fact that
LNG retrofit costs grow less than proportionally to fuel consumption, in our example the
LNG retrofit option appears more attractive. Fuel savings can be so relevant that in the
2030 horizon, i.e., in the case of a newer vessel with 17 REL, the value of the option to
invest in LNG now is the highest for differential of 90%. It should be noted that in the
2030 horizon, the option to invest in EGCS now has at least the same value as investing









A real option application to investment in low-sulphur maritime transport 13












in LNG in 2015 for LNG price differentials between 30% and 60%. This is because the
savings in the near future are too high to make a deferral strategy attractive, but not high
enough to overcome the uncertainty associated with the price differentials and warrant a
large capital investment as for higher price differentials. The savings obtainable through
the EGCS are in general lower, but less uncertain, since in the model we assume the price
of distillates to be correlated to the price of HFO.
Table 3 below shows an example for a Handysize vessel of the option values, CapEx
and OpEx. It should be noted that this analysis does not consider the exercise price of the
option. In other words, acquiring the option to defer the investment has a cost, namely the
RF that constitutes the price of acquiring the option. An accurate comparison among
various options has to consider also the RF for every strategy and is discussed more in
detail in Section 3.4.3.
Table 3 Summary of the option analysis results for 50% fuel price differential and Handysize
vessel; million dollars (2020, 2030)
OpEx
b
Savings
b
Option value (C)
Alternative CapEx
a

2020 2030

2020 2030

2020 2030
Base line - 24,18 35,91 - - n.a. n.a.
S1) EGCS now 2,15 18,46 26,16 5,72 9,76 2,89 6,66
S2) EGCS in 2015
c
2,46 18,46 26,16 5,72 9,76 3,05 6,82
S3) EGCS in 2017 2,81 20,49 28,18 3,69 7,73 1,96 4,59
L1) LNG now 18,00 13,01 18,42 11,17 17,49 - -
L2) LNG in 2015 20,61 14,85 20,26 9,33 15,66 10,54 6,62
L3) LNG in 2017 23,59 18,38 23,79 5,80 12,13 16,63 10,72
Notes:
a
CapEx are discounted at 7%.
b
OpEx and Savings are expected value of the sumof the yearly OpEx and savings
discounted at the internal firm discount rate, 15%.
c
The savings obtainable in investing in the scrubber today or in 2015 are the same
since there is no value in using a scrubber between today and 2015, as ships can
use HFO.
3.4.2 Critical threshold to invest
Interesting insights can be obtained from the analysis of the critical threshold to invest
(Figure 3). The lines indicate those combinations of LNG price differentials and CapEx
that bring the option of investing now in a LNG retrofit or an EGCS in the money. We
see that in the area marked with ‘do not invest’, the CapEx are too high for the savings
that can be obtained to justify investing now. In the area a + c, the CapEx are low enough
so that the option of investing now in LNG retrofit is in the money in a 2030 horizon, but
not for an EGCS. Similarly in area e + f, the option of investing in an EGCS is in the
money (while investment in LNG retrofit now is not).
The area marked by the character b indicates combinations of LNG price differentials
and CapEx that make any investment strategy viable but only in a 2030 time horizon. The
area c + d (or f + g) indicates those combinations of LNG price differentials and CapEx
that make only the option to invest in LNG retrofitting (or in an EGCS) in the money in
the 2020 time horizon. Finally in area h both investment strategies are in the money
independently of the ship REL.
The figure shows that the longer the time horizon, the higher is the amount of CapEx
that can be justified in the investment. Since the attractiveness of an EGCS is









14 M. Acciaro












independent of the LNG price differentials, the threshold lines are parallel to the
horizontal axis and move upwards when the REL of the vessel increases.
Figure 3 Critical CapEx thresholds to invest (y-axis) as a function of LNG price differential
(see online version for colours)

3.4.3 Deferral option value
As discussed previously it is possible to calculate the value of the deferral option. An
example of these values is presented in the table below. Figures 4 and 5 show the value of
the deferral option in the case of a Handysize vessel and an Aframax for various fuel
price differentials. The curves show similar shapes although the deferral option curve is
steeper for the Aframax vessel than for the Handysize.
While the deferral option to 2017 has the highest value for low LNG price differential
rates, we observe that the deferral option to 2015 becomes more valuable in the 2030
horizon for LNG price differential rates above 50%. This indicates that the savings
obtainable through investment in LNG are high enough to justify accepting a higher risk
and investing two years earlier. For very high LNG price differential rates, the option to
defer becomes out of the money. This is because the deferral option value is calculated as
the difference between the value of an option to invest in the future, the revenue forgone
by waiting, that is the exercise price of the option, and the value of the option to invest
now.
Table 4 Deferral values and revenue foregone (RF), 50% fuel price differential and Handysize
vessel; million dollars (2020, 2030).
Option value (C) Deferral value (D)
Alternative
2020 2030 2020 2030
Revenue foregone (RF)
S2) EGCS in 2015

3,05 6,82 0,16 0,16 -
S3) EGCS in 2017 1,96 4,59 - - 2,03
L2) LNG in 2015 10,54 6,62 8,70 4,78 1,83
L3) LNG in 2017 16,63 10,72 11,26 5,35 5,36









A real option application to investment in low-sulphur maritime transport 15












Figure 4 Value of deferral option, Handysize vessel (see online version for colours)

Figure 5 Value of deferral option, Aframax vessel (see online version for colours)
 
3.4.4 Decision lines: invest now or defer
The discussions presented in the previous sections can be summarised using decision
lines. Decision lines are points on the plane representing CapEx and fuel differentials,
where the value of the option to defer minus the exercise price of the option (i.e., the RF)
equals the value of the option to invest now. Above the decision line, management is
better off by deferring the investment, while below the line, investing now should be
preferred. As is to be expected, a longer deferral period, increases the attractiveness of
investing now, since the RF in case fuel prices develop favourably is higher.









16 M. Acciaro












It is less intuitive to understand why a longer REL for the vessel (i.e., longer vessel
utilisation time horizon), increases the attractiveness of investing now. For the same LNG
price differential, a longer REL increases the amount of CapEx that can be paid now and
recovered up to 2030, thus increasing the value of the option to invest now more than the
value of the option to defer. The RF by delaying the investment remains the same, as it is
independent of the REL of the vessel. A longer REL intuitively lowers the risk associated
with an investment today, therefore implicitly lowering the attractiveness of delaying an
investment.
Figure 6 The LNG retrofit decision line: invest now or defer (see online version for colours)

Figure 7 Optimal investment decision strategy spaces (see online version for colours)










A real option application to investment in low-sulphur maritime transport 17












We can calculate also the CapEx level that equates the value of the option to defer of two
years to the value of the option to defer of four years. These new CapEx levels can be
plotted together with the CapEx levels from figure 6 that equates the value of the option
to invest now and to defer. This comparison enables us to define the optimal strategy for
various fuel price differentials and CapEx levels (Figure 7). Figure 7 shows that for high
levels of CapEx and small differences between the price of LNG and the price of
distillate fuels it would be better to defer the investment for four years. For medium
CapEx and moderate to high differentials, a shorter deferral time appears more
appropriate. Finally for lower CapEx levels and high fuel price differentials, immediate
retrofitting should be preferred. It should be noted that in this analysis options are not
compound options, i.e., we do not model explicitly the decision of waiting until 2015 and
then deferring investment further to 2017.
4 Concluding remarks
This article offers an application of ROA in the area of green shipping. The method
appears very promising since it enables the inclusion of investment time flexibility in the
decision analysis. The possibility of delaying an investment, in what can be called a ‘wait
and see’ strategy, is often connected to the need for the shipowners to avoid being
locked-in in a technology that, for example, would make it difficult to resell the ship on
the second hand market.
In the specific case of a Handymax vessel, the paper shows that while investment in
LNG does not appear to be justifiable under current market conditions, it can make
economic sense as early as 2015. The best alternative for compliance with sulphur
emission regulation depends on the expectations on the price difference between LNG
and oil based fuels and to a large extent to the level of CapEx needed for an LNG retrofit.
A comparison with the use of an EGCS shows that while EGCS CapEx are lower, its use
does not allow for the exploitation of low LNG prices. The model suggests that under
current assumptions, it is preferable to wait and observe the developments of the LNG
market before committing large resources in new investments.
The use of real options in the highly uncertain operating environment of international
shipping appears very promising in understanding the investment decision processes of
shipowners and in providing assistance in determining the optimal strategy for
compliance with environmental regulation. In particular, the upcoming more stringent
international environmental regulation related to air emissions makes it more urgent to
find alternative and better ways to model investment decisions. This paper has focused on
sulphur oxides emissions, but real options could be similarly applied in the assessment of
the feasibility of abatement strategies for carbon dioxide or nitrogen oxides. Further
applications may include investment in ballast water treatment or in general engine
efficiency.
The methodology also allows for accounting for the barriers to the implementation of
energy efficiency technologies that have been observed in the industry. There is evidence
that uptake of new technologies that can potentially contribute to the reduction of the fuel
costs is sluggish in shipping even during economic downturns, when it would be
expected that incentives for the implementation of energy efficiency strategies would be
the strongest. It would be interesting then to model investment in new technologies as a
combination of options to grow and option to defer.









18 M. Acciaro












Acknowledgements
A preliminary version of this paper has been presented that the SIG 2 WCTR conference
in Antwerp, 21–22 May 2012. The author would like to acknowledge the contribution of
Martin C. Wold and Peter N. Hoffmann who provided their expertise on the economic
and technical aspects of low-sulphur shipping as well as part of the data for the ROA, and
to Øyvind Endresen and Magnus S. Eide, who provided valuable inputs to this paper.
Some of the ideas developed in this paper are the result of research conducted in the Low
Carbon Shipping project under the auspices of the Research Council of Norway, and in
the DNV Research and Innovation Internal Project Regulatory Outlook. We acknowledge
also the insightful comments of two anonymous referees. The usual disclaimers apply.
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A real option application to investment in low-sulphur maritime transport 23












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Notes
1 In addition to the warming effects of carbon dioxide, emissions of sulphur dioxide (SO
2
) cause
cooling as they interact with aerosols and particles and affect cloud formation. Furthermore
nitrogen oxides increase the levels of ozone, which is a GHG, causing warming, but reduce
methane, causing cooling (Fuglestwedt et al., 2009). Overall the largest individual
contribution fromshipping to the change in the Earth-atmosphere energy balance (radiative
forcing) is related to changes in the formation of low maritime stratus clouds. These clouds
increase reflectivity and enhance radiative forcing, having as a major result cooling of the
atmosphere (Laurer et al., 2009). It should be stressed, however that, while the climate
response to sulphur dioxide is in the order of decades, as sulphate has a residence period in the
atmosphere of roughly one week, carbon dioxideremains in the atmosphere for a long time
and climate response is of the order of centuries (Laurer et al., 2009).
2 Road diesel oil limit is 0.001% of mass, equivalent to 10 ppm; current global marine fuel limit
as set by IMO since 1st of J anuary 2012, is 3.5% or 35’000 ppm; current ECA limits are 1%,
or 10’000 ppm.
3 HFO prices, and marine fuel prices in general, vary frombunkering location to bunkering
location, and accurate comparisons are difficult since the fuel quality can differ even for port
in the same country. Most fuels are also sold on weight, but since their energy contents differ,
prices per unit of weigh cannot be compared. While in general this is not a major problem
when oil based fuels are compared, it is an issue with comparison with LNG, that has a higher
energy content per unit of mass. Recent HFO prices are between US$ 5 and US$ 15 per mBtu
(around US$ 600 per tonne), while distillate prices are between US$ 10 and US$ 30 per mBtu
(today around US$ 1,000 per tonne). There is no global price market for LNG, which
fluctuates between US$ 4 and US$ 15 per mBtu (http://www.bunkerworld.com).
4 Currently MARPOL contains six annexes that cover various sources of pollution fromships.
IMO conventions and their annexes alone are not valid without ratification and
implementation by sovereign States. The six annexes cover oil (Annex I); noxious liquid
substances carried in bulk (Annex II); Harmful substances carried in packaged form (Annex
III); Sewage (Annex IV); Garbage (Annex V); and air pollution (Annex VI). Becoming party
to MARPOL requires acceptance of Annex I and II, while acceptance to Annexes III to IV is
on a voluntary basis. All annexes have been ratified by the necessary number of States to be
legal. Every party in MARPOL is responsible for the implementation of the convention.
5 MEPC.184 (59).
6 It should be noted that ECAs generally include restrictions on other pollutants, such as NO
x
.
7 Since trade is not immutable, shipowners have always the possibility to modify trade patterns
outside of ECA or scrap the vessel. This in essence is equivalent to reducing their sunk costs
and is always an alternative that should be evaluated. Nonetheless this alternative is less
interesting from an investment point of view and is related to a variety of issues, such as if
there will be differentials between freight rates within the ECAs and outside the ECAs, scrap
values, etc. In this paper we will ignore this possibility.
8 The IMO GHG study calculates that the total bunker consumption for the Baltic and the North
Sea SECAs account for 27 million tonnes [Buhaug et al., (2009), p.42, Table 4.6] or 8% of
total global fuel consumption. This accounts for more than half of the bunker fuel
consumption in Europe and is in line with other estimates (e.g., Johansson et al., 2011, that
estimate fuel consumption in the Baltic at 6.2 million tonnes per year). The inclusion of the
North American newly established ECA will increase the demand of low-sulphur bunker
fuels. Wang et al. (2007c) and Corbett et al. (2006) estimate approximately 9 million tonnes
for the North American ECA in 2002. This would lead to a rough estimate for the three ECA
areas in the range of at least 36 million tonnes, more likely in the range of 40 million tonnes,









24 M. Acciaro












while a recent DNV publication, Shipping 2020, estimates 45 million tonnes. EPA (2009,
pp.3-2, 3-3) estimates for the ECA North America in 2020, that international trading ships will
consume 10.7 million tonnes of fuel within the modelled ECA boundaries, for a total of
16.2 million tonnes including domestic ships. If we apply similar growth rates as those used in
the EPA report we can expect demand for low-sulphur bunker fuel to reach approximately
60 million tonnes by 2020 globally (in the range of 10% of global bunker consumption).
European supply was (Pappos and Skjølsvik 2002) in the range of 6.5 million tonnes of
low-sulphur fuels of which the marine share counts for less than a million tonnes annually.
Even doubling that share, it would be far short of meeting EU demand. And similarly in the
US ECA rise in low-sulphur fuels will be substantial (EPA, 2009).
9 Hydrotreating capacity that seems to be the most viable option for producing low-sulphur fuel
oil is mainly available in Asian refineries today. The dilemma for the refineries is that if they
want to invest in upgrades to transformthe HFO into higher quality products, they can more
easily invest in technologies that would enable themto produce gasoline/diesel (Cracking
FCC/HCU) that can give a better margin than low-sulphur fuel oil. For now indications show
that there are no large scale plans fromthe refineries to take action to be able to meet a
possible higher demand for low-sulphur fuel oil in 2020.
10 They include open loop systems based on sea water such as the Hamworthy Krystallon
system. This has been installed on Holland-America’s ‘Zeendam’ with installed engine power
21 MW. Other systems are closed loop freshwater systems with addition of alkalinity (NaOH)
proposed for example by Wärtsilä. Clean Marine (Vortex) systems are also another alternative.
They are hybrid systems that make use of cyclone technology to ensure close turbulent contact
and reaction between wash water (sea or fresh water) and the flue gas with possible addition of
alkaline agent. There are also systems where hot exhaust gas is fed through a packed-bed
absorber filled with lime [calcium hydroxide Ca(OH)
2
] in the formof granulate pellets. These
systems are generally referred to as couple systems or dry scrubbers and make use of chemical
reactions that transformSO
x
and produce gypsum. Finally there is also an alternative known
as ECOSPEC (CSNO
x
), which claims to remove SO
x
, NO
x
, CO
2
and PM by running exhausts
through electromagnetically activated water.
11 27 ships and approximately a hundred LNG carriers sailing with LNG engines today,
compared to some 80–100.000 diesel fuelled ships.
12 NO
x
emissions are reduced by 85%–90%, SO
x
and particles by close to 100%.
13 CO
2
equivalent emission reduction is estimated between 15–25% (Pitt et al., 2010; Æsøy
et al., 2011) depending on the incidence of methane accidental releases. Emission reductions
are even lower if life cycle assessment and fugitive emissions of methane and volatile organic
compounds during distribution are considered (Brett, 2008; Bengtsson et al., 2011; Bengtsson,
2011). A realistic estimation of well-to-propeller life cycle emissions is in the range of 10%
lower than diesel fuel chains (Verbeek et al., 2011). Bio LNG produced from bio-methane also
exists but it is not widely used (Ecofys, 2012).
14 It should be noted that this comparison does not take into account the costs associated with the
acquisition of the option.