Erik Johansson: Real Options in Energy Investments

While the net present value method is becoming increasingly unpopular due to its inflexible nature, the concept of real options has slowly but surely been gaining academic ground. To be able to properly valuate a gas fired turbine, it is absolutely essential to take into account the real option associated with the freedom to, at all times, switch the turbine on and off. This thesis mainly provides analysis of a binomial tree method that is used to correctly valuate a gas fired turbine. Additionally, a framework for optimal switching problems developed by Paul Fackler is applied to the problem.

It is concluded that the binomial tree method very accurately, with a relative error of up to 1.5 %, solves the valuation problem if switching can be done without a cost. For problem settings in which region switching is associated with a fixed cost, the application of Fackler's framework is more suitable. Depending on energy price modeling, it is shown that the introduction of switching costs lowers the real option value by up to 30 %.