Real Options Framework Research Articles

Renewable Energy Investments, Support Schemes and the Dirty Option

ABSTRACTIn a real options framework, we analyze the behavior of a large energy producer who can invest in a portfolio of Renewable Energy Source (RES) and dirty energy source. Competitive fuel prices challenge the investments in RES. Given a budget constraint, the agent allocates the optimal capacities of both energy instalments and selects the optimal investment time. We use the model to compare the effectiveness of classical support schemes such as Feed‐in Tariffs or Green Certificate with respect to forms of taxation of dirty technology such as Carbon Taxes or Carbon Permits. This paper proposes a conceptual framework and qualitative analysis to understand which support system enhances the attractiveness of renewable energy investments.

Optimal dynamic climate adaptation pathways: a case study of New York City

AbstractAssessing climate risk and its potential impacts on our cities and economies is of fundamental importance. Extreme weather events, such as hurricanes, floods, and storm surges can lead to catastrophic damages. We propose a flexible approach based on real options analysis and extreme value theory, which enables the selection of optimal adaptation pathways for a portfolio of climate adaptation projects. We model the severity of extreme sea level events using the block maxima approach from extreme value theory, and then develop a real options framework, factoring in climate change, sea level rise uncertainty, and the growth in asset exposure. We then apply the proposed framework to a real-world problem, considering sea level data as well as different adaptation investment options for New York City. Our research can assist governments and policy makers in taking informed decisions about optimal adaptation pathways and more specifically about reducing flood and storm surge risk in a dynamic settings.

Integrated geo-techno-economic and real options analysis of the decision to invest in a medium enthalpy deep geothermal heating plant. A case study in Northern Belgium

Deep geothermal energy (DGE) is a renewable energy source that is considered to cause a low global warming impact. The potential of DGE for heating is widespread and interest in deep geothermal heating (DGH) has been growing in Europe to help achieving the decarbonization of the heating mix. Nevertheless, despite its large potential, DGH development in Europe remains underexplored. DGH investments are hindered by the risks born by geological and market uncertainties. However, various flexibility options inherent to the development process, such as the option to abandon or defer, could partly mitigate these risks. To account for managerial flexibility in the investment analysis, this study suggests a novel real options (RO) framework. The RO model splits DGH development into five phases, and considers several compound options and geological and market uncertainties to investigate the timing and value of DGH development at the Campine Basin in Northern Belgium. The RO model is coupled to a geo-techno-economic model and is solved using the Least Squares Monte Carlo algorithm. The RO analysis finds a 51% probability of abandonment and an average deferral time for the development of 12 years. The abandon option mitigates the risk of large financial losses in case of inadequate geological conditions. The defer option allows the investors to wait for more favorable market conditions before investing, to increase the project value. The results show that DGH development in the investigated area is not economically desirable. However, the investors' flexibility increases the project value by 12.16 million EUR, compared to a conventional techno-economic analysis. The implementation of supporting policy measures improves the economic performance of the plant. The consideration of flexibility leads to supporting policy measures with 3–4 times lower governmental expenditure, compared to a conventional techno-economic analysis. This study shows that a RO approach is more suitable to investigate DGH investments than static techno-economic methods. The inclusion of flexibility allows for identifying development pathways that increase the project value and for designing more cost-efficient supporting policy schemes.

Bi-level optimisation of subsidy and capacity investment under competition and uncertainty

In this paper, we develop a bi-level real options framework for deriving the equilibrium Government subsidisation and firm-level capacity investment policy in a duopoly market structure. We find that strategic interactions with the Government may impact a firm’s capacity investment decision significantly and that the equilibrium subsidisation policy depends on both the market structure and the type of duopolistic competition. Interestingly, the provision of greater subsidy to the leader raises the follower’s incentive to invest earlier and in a bigger project. The loss in value of the leader, due to the follower’s entry, relative to the monopolist increases with economic uncertainty and, although a subsidy can mitigate this loss, its effect becomes less pronounced as economic uncertainty increases. We also find that a profit (welfare)-maximising Government does not offer (offers) a subsidy in a highly uncertain environment or upon low tax rate, while higher tax rate does not always decelerate investment. Finally, we find that while competition is always desirable for a social planner, a profit-maximising Government may benefit more under pre-emptive competition.

Optimal investment timing and size decision‐making with jump risk and time‐inconsistent preferences

AbstractThis paper analyzes a firm's investment timing and capacity decision by considering the manager's time‐inconsistent preferences and continuous economic depreciation of the capital stock cannot be completely offset. The demand shock of the underlying product evolves according to a double exponential jump‐diffusion process. Within a real options framework, we derive the explicit expressions for the optimal investment threshold and investment size when the manager is sophisticated. We find that time‐inconsistent preferences will lead the firm to delay investment when capital depreciation rate is low and accelerate investment when the rate of capital depreciation is high. Further, we show that capital depreciation rate has a monotonic positive effect on the investment size of a time‐consistent manager but a non‐monotonic effect on that of a sophisticated manager. A sophisticated manager tends to choose a smaller investment size than a time‐consistent manager. Finally, we demonstrate that compared with the geometric Brownian motion, the firm invests later with a larger capacity under the jump‐diffusion model.

Realizing potential: a real option perspective on communities of practice in organizational transformation

This research aims to explore the recognized advantages of Communities of Practice (CoPs) in enhancing knowledge sharing and spurring organizational transformation. Despite their acknowledged importance, CoPs often receive inadequate attention or representation in numerous organizations, likely due to leaders' unfamiliarity or insufficient skills to manage such groups. This study introduces the "Real Option Perspective" as the recommended approach for top executives to understand and leverage CoPs. Initially, it clarifies the concepts of CoPs and the Real Option Perspective, highlighting their significance. These concepts then lay the groundwork for developing a management model for CoPs. The proposed management trajectory for CoPs involves five phases: Investment in CoPs, Recognition of Stagnation, Re-engagement with CoPs, Transition of Value, and finally, Dissolution and Feedback. This research seeks to expand the applicability of the Real Options framework in managing CoPs, providing leaders with strategic insights to fully realize the potential of CoPs in line with organizational objectives.

Production flexibility and trade credit under revenue uncertainty

AbstractIn an uncertain economic environment, the ability of firms to adapt their production levels to unforeseen market demand is critical for their investment, financing and trade credit policies. This paper focuses on the impact of production flexibility on trade credit values and maturity in the presence of uncertain demand. We develop a continuous‐time real options framework where a buyer firm with capacity constraints orders input goods on credit from a supplier. The supplier optimally chooses the trade credit maturity, considering its influence on the buyer's optimal quantities and default timing. We distinguish between flexible firms, capable of suspending production during adverse conditions, and rigid firms, constrained to constant full‐scale production. Our findings reveal that production flexibility positively affects trade credit values and maturity. Flexible firms invest in larger capacity, default later and order larger quantities, resulting in higher trade credit values. Suppliers extend longer maturities to flexible firms, reflecting their higher creditworthiness and the positive effects of extended trade credit on their installed capacity. Furthermore, we explore extensions to our framework, including switching costs, entry timing, interactions between debt and trade credit and a non‐cooperative bargaining game.

Corporate ESG investments and Firm's value under the real-option framework: Evidence from two world-leading economies

Under the UN sustainable development goals (SDGs), the United States (US) and China have ambitious environmental, social, and governance (ESG) investment plans. However, dichotomy is found in the literature about how rising ESG practices affect firm value (FV). This study examines the linear and nonlinear effect of ESG practices on FV and how growth-option value (GV) moderates this connection in the real-option framework. We use data on 5220 listed US and Chinese firms from 2018 to 2022 with a generalized method of moments model. The empirical results confirm that ESG practices nonlinearly affect FV, implying that ESG practices turn FV trajectory from positive to negative, and the degree of this effect varies across the sample but is more pronounced at Chinese firms than US firms. We also find that GV negatively moderates the nexus between ESG practices and FV across the sample. Our endogeneity-adjusted results pass robustness tests and have important policy implications.

A Real Option Analysis of the “Flats for Land” System - an Idiosyncratic Equity Financing Mechanism on Real Estate Investments

A typical real estate development project encounters an entrée capital expense for land purchase that is not immediately recovered until the allocated capital for the land acquisition is replaced with new capital that converts the land to a rentable building space. This article presents an idiosyncratic equity financing scheme that eliminates the sunk cost for a land purchase over a real estate development, within a real options framework. The study provides a model solution, numerical results of the option value, and the optimal investment threshold of a real estate development that is initiated through the “flats for land” scheme.

Using �Greeks� from a Dynamic Program Real Option Framework to Quantitatively Manage an Innovation Project/Startup

In this paper, we extend the Dynamic Programming Real Option Framework via a numerical example (Kumiega, Sterijevski and Van Vliet, 2023). The numerical example details a new idea called control maps. The control maps are multi-state �Greek� that will allow management to make more robust decisions at project gate meetings. This framework will shift the decisions at each gate from a purely qualitative decision to quantitative decision. The qualitative decision will be based upon the change in the current project�s expected value and the additional projected cost to change state at a gate. Simulated costs and times to completion are generated by a continuous-time Markov chain with states.

A Real Option Analysis of the “Flats for Land” System - an Idiosyncratic Equity Financing Mechanism on Real Estate Investments

A typical real estate development project encounters an entrée capital expense for land purchase that is not immediately recovered until the allocated capital for the land acquisition is replaced with new capital that converts the land to a rentable building space. This article presents an idiosyncratic equity financing scheme that eliminates the sunk cost for a land purchase over a real estate development, within a real options framework. The study provides a model solution, numerical results of the option value, and the optimal investment threshold of a real estate development that is initiated through the “flats for land” scheme.

A deep real options policy for sequential service region design and timing

There is a need for strategic flexibility in well-timed deployment decisions in the design and timing of mobility service regions, i.e. cast as ‘real options’. This problem becomes increasingly challenging considering the multiple interacting real options in such deployments. We propose a scalable machine learning (ML) based real options (RO) framework for multi-period sequential service region design and timing problem for mobility-on-demand (MoD) services, framed as a Markov decision process with non-stationary stochastic variables. A value function approximation policy from the literature uses multi-option least squares Monte Carlo simulation to get a policy value for a set of interdependent deployment decisions as deferral options (i.e., CR policy). The objective is to determine the optimal selection and timing of a set of zones to include in a service region (which to add now, which to defer to a later time to reconsider). However, prior work required explicit enumeration of all possible sequences of deployments (i.e. 5 options translate to 120 sequences). To address the combinatorial complexity arising from sequence enumeration, we propose a new variant ‘deep’ real options policy using an efficient recurrent neural network (RNN) based ML method (i.e., CR−RNN policy) to sample sequences to forego the need for enumeration, making the network design and timing policy tractable for large scale implementation. Experiments based on multiple service region scenarios in New York City demonstrate the efficacy of the proposed policy in substantially reducing the overall computational cost (i.e., time reduction associated with the RO evaluation of more than 90% of total deployment sequences is achieved), with zero to near-zero gap compared to the benchmark. We validate the model in a case study of sequential service region design for expansion of MoD services in Brooklyn, NYC, under service demand uncertainty. Results show that using the CR-RNN policy in determining optimal real options deployment strategy yields a similar performance (≈ 0.5% within the CR policy value) with significantly reduced computation time (about 5.4 times faster).

The effects of labor choice on investment and output dynamics

We incorporate both labor and capital as production inputs and discuss the effects of labor choice on a firm’s optimal investment decision and output dynamics based on real options framework. In particular, we introduce different levels of labor flexibility and examine how it affects the firm’s investment and employment strategy. We show that upward-only adjustable labor, which can arise from employment protection, discourages investment and makes a negative short-run impact on labor employment but a positive impact in the long-run. We also show that the firm invests earlier and produces more at the investment timing when it is either highly labor-intensive or highly capital-intensive. The impact of labor share on output is more pronounced as time elapses and it is more significant when labor is only upward-adjustable than the case of fully flexible labor. Furthermore, we show that uncertainty can make both positive and negative impacts on investment, but that the latter is more pronounced when the labor share is high.

Revenue and risk of variable renewable electricity investment: The cannibalization effect under high market penetration

Wind and solar power depress market prices at times when they produce the most. This has been termed the ‘cannibalization effect’, and its magnitude has been established within the economic literature on current and future markets. Although it has a substantial impact on the revenue of VRE technologies, the cannibalization effect is neglected in the capital budgeting literature, including portfolio- and real options theory. In this paper, we present an analytical framework that explicitly models the correlation between VRE production and electricity price, based on the production costs of surrounding generation capacity. We derive closed-form expressions for the expected short-term and long-term revenue, the variance of the revenue and the timing of investments. The effect of including these system characteristics is illustrated with numerical examples, where we find the cannibalization effect to decrease projected profit relative to investment cost from 33% to between 13% and −40%, depending on the assumption for the future VRE capacity expansion rate. Using a real options framework, the investment threshold increases by between 13% and 67%, due to the inclusion of cannibalization.

Valuing Forestry Agronomic Potential under Seasonal Mean-Reverting Prices

In the valuation of forest resources, the alternative use of the land is one of the central themes. In most cases it is made without taking into account the uncertainty and the possible flexibility of the alternative use. Within these alternatives, the strategy of shifting to a more profitable and sustainable crop is a well-studied topic in forest research. Although the transformation opportunity could add great value to the project, the valuation of this flexibility is obviated by traditional discounted cashflow criteria (NPV). The application of real options theory (ROT) makes it possible to assess this flexibility based on the uncertainty that the transformation entails. However, the hypotheses that are made about the future evolution of the underlying asset, in this case the value of the new crop, may condition the precision of the result. Usually some researchers model these conversions under the hypothesis of geometric Brownian motion (GBM), hypotheses that are not plausible when the new crop has a strong seasonal component. In this work, an adapted model framework is proposed to evaluate forest transformation opportunity into another crop when land use has both high agronomic potential and high seasonal component, a context in which classic real options framework is not applicable. As a work based on a theoretical model, after methodological motivation, the strawberry crop is chosen as alternative due to its seasonal component. Using private data for this crop, we model through the Ornstein–Uhlenbeck process, with mean-reversion (MR) to a seasonal component, and then we use of Longstaff and Schwartz’s algorithm to calculate the option value. The results show that when considering flexibility in option valuation it leads to an increase on the return of more than 4%. Furthermore, robustness analysis evidence shows that option value is very sensitive to seasonal component, reinforcing previous evidence that suggests that the MR process offers a more accurate and appropriate valuation over the traditional GBM in the arena of agronomic potential valuation. Specifically, the result of valuing this transformation through the MR process is between 1.5 and 1.7 times the value of the NPV, which results in approximately a 13% annual return. If GBM had been used, the valuation would have been a 72% annual return, an unrealistic result in this context, due to the non-consideration of the seasonal mean-reverting prices process.

Competition, investment reversibility, and equity risk premium

This paper investigates the role of investment reversibility in determining the relationship between product market competition and equity risk premium. We develop a unified real-option framework involving corporate investment and disinvestment decisions in a continuous-time Cournot–Nash equilibrium. The effect of competition on a firm’s risk premium induced by contraction options is negative and similar to that on the risk premium induced by expansion options; however, for assets in place, more competition results in a higher risk premium by increasing operating leverage. Notably, investment reversibility rather than product market demand moderates the competition-risk premium relationship. Our model predicts that the equity risk premium is more negatively correlated with the level of competition if investments are more reversible because firms are more likely to adjust their capacity in response to uncertain demand and this flexibility attenuates the positive operating leverage effect. We find robust empirical evidence to support our theoretical prediction.

Opportunity costs and the value of corporate social responsibility: evidence from firm dividend policy

ABSTRACT Theories of CSR value under a real-option framework suggest that the payment of dividends serves as an opportunity cost. One of the resulting predictions is that the value of CSR spending is lower for dividend paying firms. We examine this prediction empirically. While we find that CSR is positively related to firm value for both dividend payers and non-payers, CSR is roughly 50% less valuable to dividend payers than non-dividend payers.

A real-options analysis of climate change and international migration

AbstractThe potential impact of climate change on international migration patterns has recently received considerable attention, yet much of the empirical literature fails to find increases in international migration due to climate change. This paper attempts to resolve this “immobility paradox” by applying a real-options framework to the relationship between climate change and international migration. This framework suggests that individuals may postpone their migration response to climate change in the face of uncertainty and only migrate once impacts of climate change have exceeded certain thresholds. We test this prediction using semiparametric regression methods which allow us to empirically identify the threshold effects implied by the real-options framework. However, the findings are generally inconsistent with such threshold effects. Rather, the results suggest that in low-income countries, individuals’ migration response is hampered by the existence of liquidity constraints. These are likely to become more binding due to climate change-induced decreases in agricultural productivity.

Synchronizing decisions: A dynamic programming, real option framework for New Product Development with stage-to-stage correlations

Much research has investigated the application of real options to staged, new product development projects. Still, this literature has not addressed an important intuition�that bad projects may stay bad. A new product development project or a technology startup backed venture capital may include stage-to-stage dependencies. Its �state� at one gate may influence the transition probabilities at later gates. We develop a novel real option model that captures this intuition using dynamic programming and serial correlations. In a subsequent paper, we introduce partial derivatives similar to the Greeks that we named �control maps�. These control maps will assist the firm�s management to assess the financial impact of resource reallocations to project success factors. Such reallocations have the intent of turning bad projects into good ones. Thus, the proposed framework enables management to synchronize its management decision with financial ones.

The impacts of share pledging on firm investment timing and valuation

This paper applies a model in the real options framework to analyze the impacts of controlling shareholder’s share pledging on corporate investment timing and valuation. We find that the optimal investment timing shows an inverted U-shape with the pledge ratio, indicating that share pledging exacerbates firms’ over-investment and worsens firms’ under-investment. Furthermore, share pledging hurts firms’ option value unless active measures are taken to control the pledging risks. The maintenance requirement can keep controlling shareholder from irrational early investments and protect investors from severe wealth losses. In addition, our work can provide testable empirical implications.