Real Options Valuation of US Federal Renewable Energy Research, Development, Demonstration, and Deployment

Benefits analysis of US Federal government funded research, development, demonstration, and deployment (RD3) programmes for renewable energy (RE) technology improvement typically employs a deterministic forecast of the cost and performance of renewable and nonrenewable fuels. The benefits estimate for a programme derives from the difference between two forecasts, with and without the RD3 in place. The deficiencies of the current approach are threefold:

1. it does not consider uncertainty in the cost of non-renewable energy (NRE), and the option or insurance value of deploying RE if and when NRE costs rise;
2. it does not consider the ability of the RD3 manager to adjust the RD3 effort to suit the evolving state of the world, and the option value of this flexibility; and
3. it does not consider the underlying technical risk associated with RD3, and the impact of that risk on the programme's optimal level of RD3 effort.

In this paper, a rudimentary approach to determining the option value of publicly funded RE RD3 is developed. The approach seeks to tackle the first deficiency noted above by providing an estimate of the options benefit of an RE RD3 programme in a future with uncertain NRE costs. While limited by severe assumptions, a computable lattice of options values reveals the economic intuition underlying the decision-making process. An illustrative example indicates how options expose both the insurance and timing values inherent in a simplified RE RD3 programme that coarsely approximates the aggregation of current Federal RE RD3. This paper also discusses the severe limitations of this initial approach, and identifies needed model improvements before the approach can adequately respond to the RE RD3 analysis challenge.