Real options valuation of US federal renewable energy research, development, demonstration, and deployment

Abstract

Benefits analysis of US Federal government research, development, demonstration, and deployment (RD 3) programmes for renewable energy (RE) technology improvement typically employs a deterministic forecast of the cost and performance of renewable and non-renewable fuels. The benefits estimate for the programme derives from the difference between two forecasts, with and without the RD 3 programme in place. Three deficiencies of this approach are that it ignores: (1) uncertainty in the cost of non-renewable energy (NRE); (2) the possibility of adjustment to the RD 3 effort commensurate with the evolving state of the world; and (3) the underlying technical risk associated with RD 3. In this paper, an intuitive approach to determining the option value of RE RD 3 is developed. This approach seeks to tackle the first two deficiencies noted above by providing an estimate via a compound real option of an RE RD 3 programme in a future with uncertain NRE costs. A binomial lattice reveals the economic intuition underlying the decision-making process, while a numerical example illustrates the option components embedded in a simplified representation of current US Federal RE RD 3.