Applying Real Options Theory in the Electrical Energy Sector

Abstract

Real options theory is the newest expansion of standard investment evaluation methods and one that is at the same time suitable for eliminating most of their inadequacies. Similarly to financial options, the possession of real options –rights not obligations – means that operational or production hedge mechanisms complementing the management tool-kit with flexibility and the capability to respond to the environment are acquired by means of interpreting options inherent to financial products for physical assets. This study aims to analyse how real options took root in investment evaluation theory, along with the types of real options and the valuation procedures available for them, moreover to illustrate real options analysis in the course of individual level investments in the electrical energy sector. By describing binomial pricing as completed for 10 power generation technologies in detail, my goal was not primarily to grasp strategic value identified through real options, much rather to describe the pricing steps themselves. Based on the results, real options theory outperforms conventional investment valuation procedures both in terms of uncertainty and managing flexibility.