Projected Costs of Generating Electricity - OECD Nuclear Energy ...

The option to delay is embedded in projects where the investor firm has the exclusive rights of the
project. Thus, it has the option to delay, until certain market and regulatory conditions are satisfied.
Indeed, one of the early applications of the real options approach was to assess the value of phasing the
development of oil fields versus a strategy of developing all at once. 17 The option to expand exists in the
case where the investors take projects just because it allows them to take on another more interesting
project or just to enter in a new market. In energy markets, where future prices are uncertain, investors
are aware of the potential value of proceeding incrementally in developing new capacity. Quantitative
methodologies that assess the value of being able to defer the decision on making part of the investment
until market conditions become clearer are sought. Finally, the option to abandon is estimated in projects
where the free cash flows do not cover the expectations.
The real options methodology permits the financial valuation of the previous options and adds considerable
flexibility in the classic investment appraisal methodology. The flexibility to valuate other options,
except the previously mentioned also exists, but it is out of the present scope and a matter of art for the
investor analyser.
Research to apply the same techniques to assess the flexibility value of different strategies for power
generation project development is still at an early stage. One study has applied the real options method to
estimate the value of developing wind power projects in stages, rather than all at once, in recognition of
the inherent flexibility of smaller plants. 18 Another study examined the cost-effectiveness of developing
an IGCC plant in phases, initially using natural gas as a fuel and thereby delaying the decision as to when
to convert the plant to using gasified coal. 19
Despite these interesting academic results, the real options approach has achieved little acceptance by
power generation investors to date. Calculating the real options value of a power plant has proven to be
a less reliable indicator of value than financial options are in the stock market, for a variety of reasons.
Unlike financial markets, forward markets for electricity and natural gas are not sufficiently liquid yet.
They are under development in several countries and regions which may change the perspective in the
future. For the time being the models must, however, rely on forecasts of future electricity and fuel prices.
These forecasts, and the correlation between electricity and natural gas prices, are highly uncertain in light
of changing volatility of these prices.
Summary
The reform of electricity markets has led to major changes in the way decisions are taken on power
sector investment which is stressed even further by the simultaneous reform of gas markets. Opening the
sector to competition has led to the internalisation of risk in investment decision-making.
The first impact of the internalisation of these risks has been a general rise in the discount rate used for
the assessment of power generation investment. Interestingly, a US analysis suggests that the choice of a
5% and 10% discount rate may well reflect the risks appropriate to regulated US utility investment in the
former case and investment in an open market environment in the latter.
However, some efforts are also being made to quantify the different investment risks posed by the different
power generation technologies. Much of the quantification to date is largely reliant on expert judgment.
Two US analyses suggest that the risks associated with US nuclear power, inclusive of the effects
of tax might be around 2.5% higher than that for natural gas. However, this result is applicable only to the
17. McCormack and Sick, 2001.
18. Venetsanos et al., 2002.
19. Smeers et al., 2001.
190