Brajkovic, Jurica, Mason, Robin and Pitarakis, Jean-Yves
(2010)
Evaluating investment in base load coal fired power plant using real options approach.
*University of Southampton, School of Social Sciences, Doctoral Thesis*, 164pp.

## Abstract

This thesis investigates the impact of uncertainty on investment in a coalfired

power plant using a real options (RO) framework. It is organized in five

chapters. In the first chapter I give an outline of the thesis.

In Chapter 2 I review the background material. I describe the electricity

sector in the pre- and post-liberalization periods and discuss the implication

of the transition on investment in new generation capacity. Further, I analyze

the mainstream approach to investment analysis used by the majority of electricity

companies, the discounted cash flow (DCF) approach. Next, I describe

an alternative approach for evaluating investments, RO.

In Chapter 3 I perform an econometric analysis of dark spread prices. I

select four different stochastic processes and fit them to the observed data.

The goal is to find which of the four processes (arithmetic Brownian motion

(ABM), Ornstein-Uhlenbeck (OU), Cox-Ingersoll-Ross (CIR) and the Schwartz

one-factor process) can best describe the evolution of dark spread prices. The

analysis shows that the CIR process is the most appropriate model to use to

represent the evolution of dark spread prices.

In Chapter 4 I evaluate an investment in a coal-fired power plant assuming

the dark spread is the only source of uncertainty and using the stochastic

processes for which I estimated parameters in Chapter 3. First I calculate the

optimal investment threshold using a traditional budgeting approach based

on the DCF principle. Following this, using the RO framework, I calculate

the optimal investment threshold for the four stochastic processes. I conclude

that one should use mean reverting process to model the investment decision

but the choice of mean reverting process does not significantly affect the

investment threshold values.

In Chapter 5 I extend the analysis and model coal and electricity prices

separately. Now the investment decision is affected by two factors: the price

of electricity (output) and the price of coal (input). The goal of this chapter is

to analyze whether this increase in complexity (going from a one-factor to a

two-factor model) affects the result obtained in the previous chapter. Given

the different dynamics of electricity and coal prices, I find that this approach

enriches the investment analysis and gives additional insights. In particular,

the higher the coal price, the greater the dark spread needs to be in order to

undertake the investment. Finally, Chapter 6 concludes.

The thesis contributes to the existing knowledge in several ways. RO have

been applied to the electricity sector before, but this is the first time they

have been applied to the evaluation of investment in a coal-fired power plant.

Secondly, this is the first time that dark spread, electricity and coal prices are

modeled for use in a RO analysis. Finally, the thesis provides a comparison

of investment analysis for a coal-fired power plant using RO based on single

and two state variables, which has not been carried out so far.

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