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Optimal Technology Choice and Investment Timing: A Stochastic Model of Industrial Cogeneration vs. Heat-Only Production

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  • Reinhard Madlener

    (Center for Energy Policy and Economics CEPE, Department of Management, Technology and Economics, ETH Zurich, Switzerland)

  • Marcel Wickart

    (Center for Energy Policy and Economics CEPE, Department of Management, Technology and Economics, ETH Zurich, Switzerland)

Abstract

In this paper we develop an economic model that explains the decision-making problem under uncertainty of an industrial firm that wants to invest in a process technology. More specifically, the decision is between making an irreversible investment in a combined heat-and-power production (cogeneration) system, or to invest in a conventional heat-only generation system (steam boiler) and to purchase all electricity from the grid. In our model we include the main economic and technical variables of the investment decision process. We also account for the risk and uncertainty inherent in volatile energy prices that can greatly affect the valuation of the investment project. The dynamic stochastic model presented allows us to simultaneously determine the optimal technology choice and investment timing. We apply the theoretical model and illustrate our main findings with a numerical example that is based on realistic cost values for industrial oil- or gas-fired cogeneration and heat-only generation in Switzerland. We also briefly discuss expected effects of a CO2 tax on the investment decision.

Suggested Citation

  • Reinhard Madlener & Marcel Wickart, 2004. "Optimal Technology Choice and Investment Timing: A Stochastic Model of Industrial Cogeneration vs. Heat-Only Production," CEPE Working paper series 04-37, CEPE Center for Energy Policy and Economics, ETH Zurich.
    • Handle: RePEc:cee:wpcepe:04-37
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    References listed on IDEAS

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    More about this item

    Keywords

    Cogeneration; Irreversible investment; Risk; Uncertainty; Real options;
    All these keywords.

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • D21 - Microeconomics - - Production and Organizations - - - Firm Behavior: Theory
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D92 - Microeconomics - - Micro-Based Behavioral Economics - - - Intertemporal Firm Choice, Investment, Capacity, and Financing
    • O33 - Economic Development, Innovation, Technological Change, and Growth - - Innovation; Research and Development; Technological Change; Intellectual Property Rights - - - Technological Change: Choices and Consequences; Diffusion Processes
    • Q41 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Energy - - - Demand and Supply; Prices
    • Q48 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Energy - - - Government Policy

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