A real option application for emission control measures

Abstract

Real Option analyses are broadly discussed in economics and finance and different analytic and numeric calculation methods for option values have been presented and successfully implemented in theoretical case studies and practical applications. However, real option analysis has not yet been applied for mandatory investments without monetary revenues, e.g. investments in pollution reduction and emission control installations in large industrial plants enforced by political regulation. The assessment of the timing of the investment, i.e. whether to invest immediately or to delay the investment in the future, is the main scope of this work. A difficulty of the underlying type of investments with regard to option valuation is that not to invest is not an option. Therefore, the frequently applied optimal stopping approaches based on investment thresholds are not applicable to this work. In the first part of the paper, specific features and characteristics of the regarded investments are analyzed and translated into financial terms of option valuation, accompanied by an overview of several relevant option valuation methods. The most appropriate methodology for the application, the Monte-Carlo-Analysis, will be assessed in more detail. Based on a two perspectives approach that analyzes possible savings and losses of a delayed investment, a case study displays the calculations and results of the developed methodology in several scenarios. The case study reveals possible influences of policy schemes and the impact of the degree of uncertainty on mandatory investments. The work has a strong methodological focus and the calculation methodology provided can be of use for investors and policy-makers, particularly with regard to investment decision-making in the real options framework and the design of political instruments such as funding schemes.