Business cycles and energy real options valuation

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Energy projects are mostly large, irreversible and highly risky investments. The real options valuation approach is widely used to value such investment projects. Indeed, papers covered in the survey article by Fernandes et al. (2011) underscore the relevance of the real options approach to value energy sector investments. However, the related literature overlooks the distributional nature of project cash flows. The work on energy real options overwhelmingly considers log-normally-distributed cash flows, despite the well-documented evidence that cash flows are normally distributed (Burg, 2018; Kanniainen, 2009; Veronesi, 1999). The log-normality cash flows assumption solves the tractability of the problem at expense of ruling out negative cash flows. In other words, the popularity of this assumption stems from its tractability rather than its realism. Given the large and irreversible nature of energy projects, distributional assumptions characterising cash flows are crucially important in these investments. Furthermore, the interaction of normally distributed cash flows with macroeconomic risk associated with business cycles can be different than that of log-normal cash flows. This paper therefore uses a real options approach to value energy projects whose cash flows follow a normal distribution and subject to macroeconomic risk.
Real options , Geometric Brownian motion (GBM) , Investment
Turalay Kenc, T., & Ekinci, M. F. (2021). Business cycles and energy real options valuation. In A. B. Dorsman, K. B. Atici, A. Ulucan, & M. B. Karan (Eds.), Applied operations research and financial modelling in energy (pp. 173-200). Springer.

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