A Real Options Model for the Disinvestment in Conventional Power Plants

Abstract

The liberalization of the energy market and the promotion of renewables lead to difficulties in the profitable operation even of many modern conventional power plants. Although such state-of-the-art plants are highly energy-efficient, they are often underutilized or even mothballed. Decisions about further operation or shut-down of these conventional power plants are in most cases characterized as being irreversible, implying uncertainty about future rewards, and being flexible in timing. A useful approach for evaluating (dis-)investment projects with uncertainties is the real options approach (ROA) [2, 14]. This valuation technique is based on option pricing methods used in finance that have been developed by Black, Scholes, and Merton [1, 11]. In the last two decades, real options models have been widely applied to analyze investment decisions under dynamic market conditions. In recent years, however, also the analysis of disinvestment decisions considering market uncertainties has gained in importance (e.g. in studies on the agricultural and dairy sector). Moreover, ignoring disinvestment options in decision-making processes can lead to incorrect valuations of investment strategies at the firm level. In this paper, we develop a real options model for the disinvestment in conventional power plants, with the aim of determining the optimal timing for the shut-down of unprofitable power plants.