Valuing the switching flexibility of the ethanol-gas flex fuel car

Abstract

Renewable energy sources are becoming more important as the world’s supply of fossil fuels decrease and also due to environmental concerns. Since 2003, when the ethanol-gasoline flex fuel car became commercially available in Brazil, the growth of this market has been significant, to the point where currently more than 50% of the fuel consumption of cars in Brazil is from renewable biofuels (ethanol). This has been made possible due to the success of the flex fuel car, which can run on ethanol, gasoline, or any mix of these in the same fuel tank, and which is sold at a premium over the non-flex models.

Flex fuel cars, on the other hand, provide the owner with the flexibility to choose fuels at each refueling stop. Given the uncertainty on future prices of ethanol and gas, this option adds value to the owner since he can always opt for the cheaper fuel whenever he fills up his car. We use the Real Options method to analyze the value of the flex fuel option assuming both a Geometric Brownian Motion and Mean Reverting diffusion processes for the prices of gasoline and ethanol and compare the results arising from both methods. We conclude that the flex option value is significant using either method and twice as high as flex premium charged by the car manufacturers, which helps explain the success that this type of automobiles have gained in Brazil since 2003. Our results also indicate that consumers should be willing to purchase flex fuel cars even if manufacturers increase the flex premium.