Water Resources and Technology Investment Under Uncertainty

http://deepblue.lib.umich.edu/bitstream/2027.42/63580/1/john rice practicum 0809.pdf

Supporting thermoelectric power generation requires a significant quantity of water, primarilyfor cooling operations. Lack of available water due to physical scarcity or thermal permit limitsassociated with the Clean Water Act 316 (a) can result in a forced curtailment of plant operation,known as a “derating event.” Depending on the duration and severity of this derating event, autility can realize millions of dollars in economic loss. To prevent such events, a power plant caninvest in alternative cooling technology that reduces the plant’s dependence on large quantitiesof water for cooling operations. Such investments however, may be difficult to justify due tolarge capital costs for water conservation technologies and highly uncertain future cost ofderating events - future derating costs are a function of climate and energy market prices. Thus,the capital decision to invest is complex. Traditional valuation approaches, like Net PresentValue (NPV) analysis, are unable to properly value irreversible investments in environments ofhigh uncertainty because they fail to account for managerial discretion and flexibility ininvestment. Real options analysis (ROA) has been proposed as a promising solution to thedeficiencies of traditional valuation methods when facing risky technology investments orventures. The valuation technique, rooted in financial option theory, incorporates “Real optionthinking” - the managerial flexibility to capitalize on opportunities as they arise and minimize theimpact of threats - is precisely what is needed when faced with the uncertain future ofirreversible technology investments. This paper applies ROA to an evaluation of the investmentin water saving cooling technology at the Allen Steam Station in the Catawba River Basin ofNorth and South Carolina. The results indicate that the use of an NPV analysis leads to anundervaluation of the project because the option value - the value of managerial flexibility - isnot included in the valuation. The flexibility of managers is an important criterion for makingdecisions regarding sunk cost investments and firms should evaluate investments with techniquesthat incorporate this option value.