Application of Real Option Methods for Emission Abatement Investments

Real option analyses are broadly discussed in economics and finance and multiple application examples have been published over the last centuries. Different calculation methods for option values have been presented and successfully implemented in theoretical case studies and practical applications. Especially in application-oriented publications, however, there is often no detailed explanation, why a specific calculation method has been chosen and which effects this may cause regarding the results as well as the transparency and practicability of the method. Therefore we will present a brief overview of the type of applications we consider - investments in emission abatement investments for large industrial plants, typically of the energy, steel or chemical sector. These investments have some specific characteristics, most importantly they are usually not economically reasonable as they do not generate noteworthy revenues, but are enforced by political regulations. We will discuss how the specific features and assumptions can be “translated” in the financial language of option valuation. Afterwards, an overview of the most relevant option valuation methods will be provided, considering analytic, numeric and stochastic approaches. ... mehrFinally, the applicability of the considered approaches to the above mentioned type of investment decisions is assessed and possible influences on results and implementation are derived thereof from a methodology oriented perspective. For the considered application, the stochastic simulation method “Least Squares Monte-Carlo-Simulation” extended by the “Exercise Boundary Parameterization Approach” seems a very promising approach due to its flexibility and the distinct deduction of a stopping rule for American options.