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investment
Jurica Brajkovic
Outline
Question: How to analyze investment in coal fired power plant in liberalized
market?
Motivation
How to value large capital investments? Utilities mostly use NPV.
Introduction Investment problem Application of real options Model Selection
Motivation
How to value large capital investments? Utilities mostly use NPV.
This was good when:
• Markets monopolized (one vertically integrated company, no
competition)
• Certain electricity prices (regulation)
• Costs could be passed on to the final consumer
• State support
• In essence, no business risk implying certain cash flows
Introduction Investment problem Application of real options Model Selection
Motivation
How to value large capital investments? Utilities mostly use NPV.
This was good when:
• Markets monopolized (one vertically integrated company, no
competition)
• Certain electricity prices (regulation)
• Costs could be passed on to the final consumer
• State support
• In essence, no business risk implying certain cash flows
But electricity markets have changed and utilities face different
conditions:
• Competition in generation
• Generators face plethora of risks: uncertain revenues and costs,
demand risk, construction, financial risk...
Introduction Investment problem Application of real options Model Selection
Question: What’s wrong with NPV?
Introduction Investment problem Application of real options Model Selection
Question: What’s wrong with NPV?
It does not recognize the following:
• Mostly, investments are not ’now or never’ decisions
• Investments are irreversible
• Underlying variables follow stochastic processes (price, cost,
demand..)
• There are options in the project (option to shut down, suspend,
expand...)
• Managers act to eliminate downsize and explore upside
Good investment tool should address these issues.
Introduction Investment problem Application of real options Model Selection
Example cont.
∞ ∞
X [E (pt ) − c] · qt X 50e − 40e
NPV = −I = − 100e = 10e
t=1
(1 + r )t t=1
(1.1)t
Example cont.
∞ ∞
X [E (pt ) − c] · qt X 50e − 40e
NPV = −I = − 100e = 10e
t=1
(1 + r )t t=1
(1.1)t
Example cont.
∞ ∞
X [E (pt ) − c] · qt X 50e − 40e
NPV = −I = − 100e = 10e
t=1
(1 + r )t t=1
(1.1)t
Plant characteristics
Assumptions:
• Analyze investment decision in a base load coal fired power plant
• Investor does not need to worry about emission permits
• Focus: what is the most appropriate stochastic process and how
does the choice affect investment decision
Assume following parameters:
Parameter Value
Project life 40 years
Capacity 500 MW
On line % 85%
Productive hours 7446
Annual production 3,723,000 MWh
Investment cost per kW 1,500 e
Discount rate 10%
Table: Investment parameters
Introduction Investment problem Application of real options Model Selection
Dark Spread
Dark spread=Price of electricity [e/MWh] - Price of coal [e/MWh]
Introduction Investment problem Application of real options Model Selection
NPV value
Stochastic processes
dp = at + σdz (1)
Table: Summary statistics for observed and 10 000 simulated price trajectories
min. median mean max. se. skew. kurtosis
Simulations -807.65 17.29 16.61 811.51 141.38 -0.03 4.01
Observed prices 1.09 20.74 24.25 121.39 14.45 1.86 9.33
Introduction Investment problem Application of real options Model Selection
Investment rule:
Ornstein Uhlenbeck - OU
The process is given by:
Weekly values
Mean reversion (k) 0.28
Long run price (µ) 24.24
Volatility (σ) 10.9
Standard error (ζ) 9.52
Table: Summary statistics for observed and 10 000 simulated price trajectories
for OU process
min. median mean max. se. skew. kurtosis
Simulations -46.11 24.13 24.17 104.79 14.44 0.01 3.01
Observed prices 1.09 20.74 24.25 121.39 14.45 1.86 9.33
Introduction Investment problem Application of real options Model Selection
Weekly values
Mean reversion (k) 0.29
Long run price (µ) 24.05
Volatility (σ) 1.94
Introduction Investment problem Application of real options Model Selection
Weekly values
Mean reversion (k) 0.365
Long run price (a) 3.367
Standard error (ζ) 0.418
Volatility (σ) 0.497
Introduction Investment problem Application of real options Model Selection
Figure: Exercise boundary for Schwartz one factor model as a function of time
Introduction Investment problem Application of real options Model Selection
Model Selection
min. median mean max. se. skew. kurtosis
Observed 1.09 20.74 24.25 121.39 14.45 1.86 9.33
ABM -807.65 17.29 16.61 811.51 141.38 -0.03 4.01
OU -46.11 24.13 24.17 104.79 14.44 0.01 3.01
CIR 0.16 21.82 23.98 134.43 12.50 1.06 4.69
Schwartz 1.17 20.61 24.44 507.60 15.49 2.19 12.88
Table: Mean values of RMSE for different processes with standard errors in
brackets
Introduction Investment problem Application of real options Model Selection