Modeling energy technology choices: Which investment analysis tools are appropriate?

Abstract

A variety of tools from modern investment theory appear to hold promise for unraveling observed energy technology investment behavior that often appears anomalous when analyzed using traditional investment analysis methods. This paper reviews the assumptions and important insights of the investment theories most commonly suggested as candidates for explaining the apparent ‘energy technology investment paradox’. The applicability of each theory is considered in the light of important aspects of energy technology investment problems, such as sunk costs, uncertainty and imperfect information. The theories addressed include the capital asset pricing model, the arbitrage pricing theory, and the theory of irreversible investment. Enhanced net present value methods are also considered. The relevance of the capital asset pricing model and the arbitrage pricing theory, given the special characteristics of energy technology investment decisions, appears limited to the value of the theories' conceptual insights. In contrast, the theory of irreversible investment and enhanced net present value are found to provide more useful modeling and analysis methods, each capable of providing important insights into the ‘energy technology investment paradox’.