Improving Economic Assessments of Clean Development Mechanism Projects Using Real Options

Abstract

Currently, there is increasing pressure from global community to reduce the greenhouse gas emissions, the main cause of climate change. One of several programs to reduce the greenhouse gas is Clean Development Mechanism or CDM by the United Nation. The amount of greenhouse gas reduction through CDM projects in developing countries can be sold to developed countries so that they can increase the maximum cap of the emissions to be emitted into the environment. It is this carbon credit from CDM projects that is of financial value, and thus should be viewed as a new type of asset. This could help improve the financial outlook of CDM projects such as renewable energy generators (REGs) because not only these projects usually involve higher costs of technology but also high uncertainty from the prices fluctuation of input commodity, output products, and carbon credits, for instance. Valuing CDM projects full of uncertainty by conventional discounted cash flow (DCF) approaches such as net present value (NPV) could underestimate the intrinsic value and inherent risk of these projects. Accordingly, the aim of this paper is to propose a new approach for valuing the financial viability of CDM projects that considers risk, flexibility, and carbon credit into the economic analysis, using real options theory and risk-flexibility theory.