Valuing Assets Using Real Options: An Application to Deregulated Electricity Markets

This paper provides a detailed case of the application of real options valuation techniques to value a contract for the use of a power generation facility. The authors' aim is not primarily to offer a valuation “recipe” for a specific type of asset, but to show how the real options framework can be actually made to work in a variety of situations. The case illustrates how minor adaptations that take into account the ways in which actual settings differ from the assumptions of standard formulas like Black‐Scholes can be used to increase the precision and realism of results. By introducing relatively simple changes to a standard options valuation model, the authors obtain results that are reasonably close to those reported for actual transactions involving similar types of assets. Despite the industry‐specific context of the analysis, the applicability of the techniques discussed in the paper should extend beyond the energy industry to other contexts characterized by similar types of uncertainty and production process, particularly those associated with minerals and other commodities.