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Evaluating investment in base load coal fired power plant using real options approach

Record type: Thesis (Doctoral)

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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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.

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Published date: November 2010
Organisations: University of Southampton


Local EPrints ID: 171553
PURE UUID: 6681b484-25f4-43b3-8964-b46db252aafa

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Date deposited: 03 Feb 2011 11:52
Last modified: 18 Jul 2017 12:15

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Author: Jurica Brajkovic
Author: Robin Mason
Author: Jean-Yves Pitarakis

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