Dr Oecon Kristin Linnerud, Cicero
In the coming years, Europe will need more electric power from renewable sources to meet our greenhouse gas and renewable targets. However, market and climate policy uncertainty affecting project cash flows could make investors hesitate to build new capacity unless profitability is significant. This follows from real option theory. Whether investors behave in accordance with this theory, is an empirical question.
In Norway there are many good sites for small hydropower. Having access to such a site is viewed as holding a real option to invest. Using data from 225 small hydropower projects we study the investment behaviour of the developers. More specifically, we test whether investments did actually occur at the optimal point in time predicted by an option-based model. This is tested against the alternative hypothesis: that investments are made when the discounted value of future cash flows are equal to or exceeds investment outlays.
Our investment models include two stochastic variables: wholesale electricity prices and green certificate prices. We calculate trigger levels for the sum of these prices, and compare these with the current long-term prices contract prices to predict the optimal decisions according to both a traditional and a real option investment rule.
We find that the option based investment rule provides a better explanation for investment decisions in small hydropower plants than does the traditional net present value rule. This suggests that new policy instruments should be designed so as to reduce investors risk and thus the social cost of achieving climate policy targets.