Valuing flexibility: The case of an Integrated Gasification Combined Cycle power plant
In this paper we analyze the choice between two technologies for producing electricity. In particular, the firm has to decide whether and when to invest either in a Natural Gas Combined Cycle (NGCC) power plant or in an Integrated Gasification Combined Cycle (IGCC) power plant, which may burn either coal or natural gas. Instead of assuming that fuel prices follow standard geometric Brownian motions, here they are assumed to show mean reversion, specifically to follow an inhomogeneous geometric Brownian motion. First we consider the opportunity to invest in a NGCC power plant. We derive the optimal investment rule as a function of natural gas price and the remaining life of the right to invest. In addition, the analytical solution for a perpetual option to invest is obtained. Then we turn to the IGCC power plant. We analyse the valuation of an operating plant when there are switching costs between modes of operation, and the choice of the best operation mode. This serves as an input to evaluate the option to invest in this plant. Finally we derive the value of an opportunity to invest either in a NGCC or IGCC power plant, i.e. to choose between an inflexible and a flexible technology, respectively. Depending on the opportunity's time to maturity, we derive the pairs of coal and gas prices for which it is optimal to invest in NGCC, in IGCC, or simply not to invest. Numerical computations involve the use of one- and two-dimensional binomial lattices that support a mean-reverting process for coal and gas prices. Basic parameter values are taken from an actual IGCC power plant currently in operation. Sensitivity of some results with respect to the underlying stochastic process for fuel price is also checked.
If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Yu-Fu Chen & Michael Funke, 2002.
"Working Time and Employment under Uncertainty,"
Dundee Discussion Papers in Economics
134, Economic Studies, University of Dundee.
- Yu-Fu Chen & Michael Funke, 2004. "Working Time and Employment under Uncertainty," Quantitative Macroeconomics Working Papers 20409, Hamburg University, Department of Economics.
- Yu-Fu Chen & Michael Funke, 2002. "Working Time and Employment under Uncertainty," CESifo Working Paper Series 732, CESifo Group Munich.
- Bhattacharya, Sudipto, 1978. "Project Valuation with Mean-Reverting Cash Flow Streams," Journal of Finance, American Finance Association, vol. 33(5), pages 1317-31, December.
- He, Hua & Pindyck, Robert S., 1992.
"Investments in flexible production capacity,"
Journal of Economic Dynamics and Control,
Elsevier, vol. 16(3-4), pages 575-599.
- Malcolm P. Baker & E. Scott Mayfield & John E. Parsons, 1998. "Alternative Models of Uncertain Commodity Prices for Use with Modern Asset Pricing Methods," The Energy Journal, International Association for Energy Economics, vol. 0(Number 1), pages 115-148.
- David G. Laughton & Henry D. Jacoby, 1993. "Reversion, Timing Options, and Long-Term Decision-Making," Financial Management, Financial Management Association, vol. 22(3), Fall.
- Kandel, Eugene & Pearson, Neil D., 2001. "Flexibility versus Commitment in Personnel Management," Journal of the Japanese and International Economies, Elsevier, vol. 15(4), pages 515-556, December.
- Metcalf, Gilbert E. & Hassett, Kevin A., 1995.
"Investment under alternative return assumptions Comparing random walks and mean reversion,"
Journal of Economic Dynamics and Control,
Elsevier, vol. 19(8), pages 1471-1488, November.
- Gilbert E. Metcalf & Kevin A. Hassett, 1995. "Investment Under Alternative Return Assumptions: Comparing Random Walks and Mean Reversion," NBER Technical Working Papers 0175, National Bureau of Economic Research, Inc.
- Cortazar, Gonzalo & Schwartz, Eduardo S., 2003. "Implementing a stochastic model for oil futures prices," Energy Economics, Elsevier, vol. 25(3), pages 215-238, May.
- Sarkar, Sudipto, 2003. "The effect of mean reversion on investment under uncertainty," Journal of Economic Dynamics and Control, Elsevier, vol. 28(2), pages 377-396, November.
- Kandel, Eugene & Pearson, Neil D., 2002. "Option Value, Uncertainty, and the Investment Decision," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 37(03), pages 341-374, September.
- Insley, Margaret, 2002. "A Real Options Approach to the Valuation of a Forestry Investment," Journal of Environmental Economics and Management, Elsevier, vol. 44(3), pages 471-492, November.
- Schwartz, Eduardo S, 1997. " The Stochastic Behavior of Commodity Prices: Implications for Valuation and Hedging," Journal of Finance, American Finance Association, vol. 52(3), pages 923-73, July.
When requesting a correction, please mention this item's handle: RePEc:eee:eneeco:v:30:y:2008:i:4:p:1850-1881. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Zhang, Lei)
If references are entirely missing, you can add them using this form.