Real Options As A Project Assessment Methodology In The Electricity Sector

Real options as a project assessment methodology in the electricity sector

Summary

This work studies the project assessment methodology with the application of real options on a small hydroelectric plant in the department of Antioquia, Colombia. The project presents an expansion option and to obtain the total value including the value of this option Risk Simulator and the Binomial Tree Methodology was used. In the development there are several sections: in the first part an introduction is made in general terms;In the second part, a brief literature review of project valuation techniques is carried out, as well as the methodology of real options and their application in the energy sector;Finally, in the last section the case of the hydroelectric power plant is developed.

Introduction

The methodology for assessing investment projects from real options has been gaining strength in recent years, especially for projects such as those of the electrical industry, because the very nature of this type of project makes them particularly sensitive toChanges in: regulatory aspects of the market, fuel prices, environment, demand and energy supply, among others. The real options manageand the tir (internal return rate)

The objective of this work is to carry out in the first instance a review of the traditional project assessment methodologies, followed by a brief theoretical explanation about real options and its close relationship with financial options, subsequently a bibliographic review of related studies of the related studies is presentedWith the assessment of projects in the electricity sector from real options and finally based on the information collected, the assessment of a project in said sector will be made.

Project valuation techniques

Traditionally to evaluate the financial viability of a project, different techniques are used that measure the returns that derive from an initial investment that later generates cash flows. The commonly used techniques are: the net present value (VPN), the internal return rate (IRR), the recovery period (PR), among others.

The main limitations of this type of financial evaluation techniques are:

• They are static models: these only consider a predetermined range to evaluate the cash flow of the project, leaving aside the possibility of evaluating its execution at another time and under other circumstances.
• They do not have flexibility: they assume that investors will not make modifications to the project during execution, thus despising changes in the environment.
• They do not have the option of postponing investment: ‘’ Investment is, from the beginning, irreversible and inevitable ’’ ’.

The most obvious differentiation between the assessment with real options and the traditional assessment methods is the importance provided to flexibility;This is one of the most important characteristics of this type of projects, since it takes into account management options such as contraction, expansion, project abandonment, among others. 

Theory of real options

In the electricity industry, the theory of real options has recently been used as a tool. This theory values management control aspects and is based mainly on the theory of financial options and business strategy, so it constitutes one of the most important bases of modern financial theory.

The real options are properly understood as “the right, but not the obligation, to take an action (for example, postpone, expand, contract or abandon) at a certain cost, called the exercise price, for a certain period of time – periodof validity of the option ". 

These investment decisions have main characteristics: they are irreversible, they are uncertain, so they are high risk and are flexible. These characteristics are not captured by traditional assessment methods, such as the net present value (VPN), the discounted cash flow (FCD), the internal return rate (IRR), the return on investment (ROI) andothers, thus leading to bad investment decisions. 

When applying real options in the assessment of a project, the results obtained by traditional assessment methods are being complemented since the latter belittle the values that projects can take when they present to some extent flexibility and uncertainty. These factors can be understood as changes in the environment and market conditions, which would finally influence the actions and decisions of the administrators or project managers.

“Various investigations have demonstrated the usefulness of the Monte Carlo simulation in the assessment of the real options, since to the flexibility advantage of the binomial model, the simulation adds the possibility of estimating the extended net value of all those projects whose treasury flows dependof the value of one or several state variables, whatever your pattern of stochastic behavior "

The Geometric-Brownian process is very useful for interpreting the behavior of financial assets prices, but it is not optimal for other non-financial variables;Not presenting this limitation in its application, the Monte Carlo simulation is considered a more appropriate tool for the assessment of real options.

The Monte Carlo simulation involves the achievement of random samples of the dynamic behavior of the sources of uncertainty on which the value of the derivative depends. The estimation of a single trajectory of the evolution of each variable is not enough to approximate the value of the option, in general, the number of trajectories increases the accuracy in the estimation of the result.

Real options in the sector

Many authors have been interested in the assessment of projects in the electricity sector, this is why literature regarding studies in this sector is extensive. These studies show that the application of real options in the electricity sector mainly considers the option to differ or delay investment as evidenced in studies.

It is expected that not all studies reach the same conclusion since different assumptions are taken into account. For example, they demonstrated in their study that by delaying or postponing the investment of a renewable energy project, losses can be incurred considering the uncertainty related to diesel and electricity;For its part, (Acevedo Prins et al., 2018) discovered the viability of a renewable energy project from the second year, where by applying a postponement option, more flexibility is given to future investors;In its study it is demonstrated as the application of real options allows not ruling for investment in the project in the first instance by observing the negative results of the indicators thrown by traditional assessment methods, this thanks to the financial evaluation adjusted to future decisionsderived from the application of real options.

Another study was (fertig et al., 2014), who analyzed the expansion plans of energy storage complexes by applying the real option to postpone the construction of the complex in question;After assessing the viability of the project based on future energy prices, it was concluded that the option should be maintained at least 8 years, a period in which more information could be obtained that finally benefiting the project strategy.

In general terms, project assessment studies in the energy sector use the Monte Carlo simulation and binomial trees as evidence in the works presented by (Mendoza-Mendoza & Gutiérrez-Alcaraz, 2016), (Frenten, Linnerud, Molnár, & Tandberg Nygaard, 2016), (Ahumada V & Andalaft CH, 2013), (Jain, Roelofs, & Oosterlee, 2013), (Ochoa, Betancur, & Múnera, 2012), (A. Cartea & González-Pedraz, 2012), (Westner & Madlener, 2012), (Min, Lou, & Wang, 2012), (Rohlfs & Madlener, 2011), (Nishimura, 2011), (Concha A, Andalaft Ch, &Farías F, 2009), (Otero, Andalaft, & Vásquez, 2008) and (Bonis et al., 2009). These authors conclude that by assessing projects of this nature with the focus of real options and with the mentioned methods, the value obtained is generally greater compared to traditional assessment methods that do not value flexibility.

It is important to mention that electricity prices are considered as the main source of uncertainty in most project assessment studies in the electricity sector, but other factors are also considered. For example, studies conducted by (Chen, Zhang, Wang, Zhu, & Li, 2018), (Bjørgum, 2016), (Scarcioffolo et al., 2018) consider as a determinant of great importance the sources of uncertainty related to governmental factors as well as technological improvements and market. On the other hand, (Ming, Ping, Shunkun, & GE, 2016) analyze the impact of uncertainty and fluctuation of the fuel price on investment.

Finally, as indicated at the beginning of this session, the project assessment literature of the electrical sector using real options is extensive so that the cases do not present a specific geographical region;However, numerous case studies are presented in the Asian continent such as (Agaton & Karl, 2018), (Acevedo Prins et al., 2018), (Chen et al., 2018), (ming et al., 2016), (Zhang et al., 2016), where projects are evaluated in the Philippines, China, Mongolia and Indonesia. For North America there are studies conducted by (Scarcioffolo et al., 2018) and (Frente et al., 2017), for South America there are the analysis carried out by (Ahumada V & Andalaft CH, 2013) and (Ochoa et al., 2012) with cases in Chile and Colombia respectively, and for Europe (Frente et al., 2016), (Fertig et al., 2014), (Gazheli & di Corato, 2013), (A. Cartea & González-Pedraz, 2012) and (Westner & Madlener, 2012) perform evaluations in Norway, Germany, Italy and Holland.

App

As a case study, there is a project that consists of building a small hydroelectric plant in the department of Antioquia with a value of $ 56.000 million as an initial investment (this value considers a turbine and the necessary adjustments to begin the operation);The project is expected to be a useful life of 50 years, a period in which the option of expanding the energy production of the project will be evaluated.

Initially the hydroelectric plant will generate 300 million kilowatts (KWH) per year, of which only 70% will be produced. The project expansion plan would be due to an increase in energy prices in the energy market. In order to carry out the expansion plan, a new turbine whose cost is $ 23 would be necessary.520 million, where an expansion of 40% would finally occur.

Taking as a reference the cost of the new turbine and the percentage of growth in case of expansion, the possibility of reviewing each year during the first 6 years of project activity is proposed to determine the viability of the expansion plan.

The objective of this work is to analyze the case in its entirety, so in the first instance the following financial factors are considered:

• The financial structure of the project is given by 60% debt and 40% capital. Debt with a period of 10 years at a rate of 15% EA (amortizations in equal proportion per year).
• The project has the following costs:
• Operations: 40% of income
• Administration, operation and maintenance: 5% of income
• Commission through intermediation: 2.7% of income.
• The project must assume the payment of licenses, environmental permits, audit, fees and insurance for a total of $ 5.000 million.
• The minimum rate required by shareholders is 25%
• The effective tax rate is 33%
• Cash flows have a perpetuity growth rate of 3%
• The energy price has a 5% growth rate

It is important to highlight that taking into account the capital structure, the minimum rate required by shareholders and the cost of debt, the average capital cost (WACC) is 16.03%.

Based on the previous data, the VPN and the project of the project were calculated. Both values ​​are detailed below:

The results thrown by the traditional assessment methods reflect the viability presented by the construction project of the hydroelectric power plant, since its net present value is positive with a value of $ 67.482.574.129 and the internal return rate of 32.54% exceeds the minimum rate required by shareholders of 25%; However, the calculation of these variables wanted to be calculated using financial simulation methodologies that sensitize the value of the project under pessimistic and optimistic scenarios. To perform the simulation, the @risk simulator application was used where the average VPN, the average pull and volatility linked to the project was calculated.

To calculate these variables, 10.000 simulations in total. The input variables considered were the following:

• For the VPN an average value of 66 was found.914.310.736, a standard deviation with a value of $ 7.271.448.307, a maximum of $ 91.461.854.426 and a minimum of $ 45.804.414.136. In both scenarios (optimistic and pessimistic) the net present value of the project is positive, which confirms the financial viability of the project.
• The internal average return rate is 32.40% and presents a standard deviation of 1.49%, the maximum and minimum values are 37.19% and 27.85% respectively. In both scenarios (optimistic and pessimistic) the values exceed the minimum rate required by the shareholders and the WACC, which provides support together with the previous VPN to proceed with the project.
• Volatility was calculated based on the following formula.

The result obtained was 64% and when performing the simulations, it was obtained that the standard deviation that could present the cash flows of 5 would.70%. The maximum and minimum values are 81.50% and 45.91% respectively.

In addition to financial simulations, a tornado -type sensitivity analysis was carried out at the value of the option. The graph and the results obtained are presented below:

• Before a 10 % change either positive or negative in the VPN value the value of the option changes by 24.54 % or -24.54 % respectively.
• Before a change of 4 % either positive or negative in the percentage of expansion of the option, the value of the latter changes by 24.54 % or -24.54 % respectively.
• Faced with a 10 % change, whether positive or negative in the initial investment, the value of the latter changes by 14.53 % to -14.53 % respectively.

It is important to remember that the project has the option to expand if an increase in energy prices is given. This option can be reviewed every year during the first 6 years, period in which it will be decided whether or not the expansion should be carried out.

The expansion option will be assessed using the real options methodology. For this, the standard deviation obtained with @risk simulator of 5.70% was used and the risk -free rate published by the Bank of the Republic to date was taken into account. (Effective to cut of 6.569%). 

In addition to this, factors such as:

Where is volatility, it is the number of times the project is reviewed per year, it is the rising factor and is the low factor. Taking these data into account and the methodology of event trees (Copeland, 2003) the underlying tree shown below was performed:

To continue with the real option valuation process and prepare the exercise tree, the cost of the new turbine necessary for expansion was taken into account, which has a value of $ 23.520 million and where the capacity of the hydroelectric power plant would increase by 40%.

When it is an expansion, the option is analyzed as an American call so the calculation of each of the exercise of the exercise of the exercise is developed as follows:

After having the tree of the exercise, the tree of the "Live" option was built. It is important to mention that for the last moment (6) of this tree the same formula used in the tree of the exercise is applied, but for the other moments the following formula is applied:

Where ov tree and tree and refer to the trees of the living option and the exercise respectively.

Based on the data obtained so far in the tree of the exercise and the tree of the living option, the tree of the option is built, where the value in each scenario is given by:

From the option of the option it can be seen that the value of the joint option is $ 11.043.251.245. In the upper right of the tree, in green, the scenarios in which it is convenient to expand the project is highlighted.

However, to obtain a more robust model 10 were made.000 simulations to calculate the average value of the option considering changes in volatility and risk free rate. The result is detailed below:

Finally, the total value of the project was calculated taking into account the average value of the option.

Initially, based on the result obtained by traditional assessment methodologies, the financial viability of the project was concluded;However, when using real options and analyzing the expansion option of the hydroelectric power plant, a possible income was received that had not been considered $ 11.080.840.620, which gives more financial attraction to the project.

conclusion

The application of real options in the assessment of projects is a very useful tool for making financial decisionand else.

In the valuations made in the electricity sector with the application of real options, the analysis of delaying or postponing investments so that this study is centering the option to expand a small hydroelectric plant has been highlighted. It was demonstrated as the option can be obtained an additional value that had not been considered by traditional assessment methods. In the case analysis, it was also discovered that variations in factors such as the net present value, the percentage of expansion and initial investment can affect the total value of the project.

It is important to mention another element that can positively affect the financial viability of the hydroelectric power plant project. According to the mining-energy planning unit (UPME), the growth of energy demand in Colombia will be approximately 3 % in the long term, that is, in a 12-year horizon the energy demand will pass from 74.835 GWh/year at 105.018 GWh/year. In addition, on the side of the energy supply, all the projections made by the UPME had the entry into operation of Hidroituango, which was estimated by the end of 2018;However, the entry into operation of this megaproject was delayed due to a series of mishaps that add another three years until the plant can generate energy. This event takes out a 2 generation capacity of 2.400 MW/h, which translates into a difference between the supply and demand that accompanied by the phenomenon of the child that is forecast by December 2018, will generate an important increase in energy prices and therefore of the estimated income of the estimated income of theProject.(Macías, 2018)

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