Igcc and NGCC

Technology choice for power plants
under mean reversion in fuel prices

+
Luis M. Abadie
Bilbao Bizkaia Kutxa
Gran Va, 30
48009 Bilbao, Spain
Tel +34-607408748
Fax +34-944017996
E-mail: imabadie@euskalnet.net
Jos M. Chamorro
University of the Basque Country
Dpt. Fundamentos del Anlisis Econmico I
Av. Lehendakari Aguirre, 83
48015 Bilbao, Spain
Tel. +34-946013769
Fax +34-946013891
E-mail: jm.chamorro@ehu.es
February 6th 2006
Abstract
In this paper we analyze the choice between two technologies for
producing electricity. In particular, the rm has to decide whether
and when to invest either in a Natural Gas Combined Cycle (NGCC)
power plant or in an Integrated Gasication Combined Cycle (IGCC)
power plant. Instead of assuming that fuel prices follow standard
geometric Brownian motions, here they are assumed to show mean
reversion, specically an inhomogeneous geometric Brownian motion.
First we use the opportunity to invest in a NGCC power plant
Earlier versions of this paper have been presented under the title "Valuing exibility:
The case of an Integrated Gasication Combined Cycle power plant". We would like
to thank seminar participants at the 9th Conference on Real Options (Paris 2005), XIII
Foro Europeo de Finanzas (Madrid 2005) and the 1st Annual Congress of the Spanish
Association for Energy Economics (Madrid 2006) for their helpful comments. We remain
responsible for any errors. Chamorro acknowledges nancial support from research grant
9/UPV00I01.I01-14548/2002.
1
2
as a base case, deriving the optimal investment rule as a function
of natural gas price and the remaining life of the right to invest.
Additionally, the analytical solution for a perpetual option to invest
is obtained.
Then we turn to the IGCC power plant which may burn either
coal or natural gas. We analyse the valuation of an operating plant
when there are switching costs between modes of operation, and the
choice of the best operation mode. This serves as an input to compute
the value of the option to delay an investment of this type.
Finally we derive the value of an opportunity to invest either in
a NGCC or IGCC power plant, that is, to choose between an
inexible and a exible technology, respectively. Depending on the
opportunitys time to maturity, we derive the pairs of coal and gas
prices for which it is optimal to invest in NGCC, in IGCC, or simply
not to invest.
Numerical computations involve the use of one- and two-dimensional
binomial lattices that support a mean-reverting process for coal and
gas prices. Basic parameter values are taken from an actual IGCC
power plant currently in operation.
Keywords: Real options, Power plants, Flexibility, Stochastic
Costs.
JEL Codes: C6, E2, D8, G3.
1 INTRODUCTION 3
1 Introduction
It is broadly accepted in the nancial literature that traditional valuation
techniques based on discounted cash ows are not the most appropriate tool
for evaluating uncertain investments, especially in presence of irreversibility
considerations, or a chance to defer investment, or when there is scope for
exible management. In these cases, it is usually preferable to use the
methods for pricing options, such as Contingent Claims Analysis or Dynamic
Programming.
On the other hand, the energy sector is of paramount importance for
the development of any society. Besides, its specic weight both in the real
and nancial sectors of the economy cannot be neglected. Therefore the use
of inadequate instruments in decision making may be particularly onerous.
In addition, the high sums involved in the energy industry, its operating
exibility and environmental impact, the progressive liberalization of the
markets for its inputs and outputs along with many types of uncertainties,
all of them render this kind of investments a suitable candidate to be valued
as real options.
The aim of this paper is to use the real options methodology to assess
decisions of investment in power plants. In particular, our rm is going
to decide simultaneously the time to invest and the choice of technology.
Specically, we compare an inexible technology (Natural Gas Combined
Cycle, or NGCC henceforth) with a exible one (Integrated Gasication
Combined Cycle, or IGCC). We derive the best mode of operation, the
value of the investments and the optimal investment rule when there is
an option to wait. We consider two mean-reverting stochastic processes for
coal and natural gas prices, both of the Inhomogeneous Geometric Brownian
Motion (IGBM) type, and also switching costs between modes of operation.
The output (electricity) price, though, follows a deterministic path. Basic
parameter values in our computations refer to an actual IGCC power plant
currently in operation.
Restricting ourselves to the energy industry, we would mention Paddock,
Siegel and Smith [23] who apply real options theory to the valuation
of undeveloped oil leases; they also provide empirical evidence of the
superiority of option values over those derived from standard Net Present
Value methods. Bjerksund and Ekern [3] value an oil eld when there is
an option to defer operation and abandon the site. Lund and Oksendal
[21] comprise several theoretical and empirical studies on the valuation of
oil investments and related issues. Kemma [15] presents some practical
case applications, with a focus on the use of real options theory in capital
budgeting decisions by an actual oil rm. More recently Ronn [26] provides
an array of applications of the real options approach to the valuation of
dierent exibilities embedded in the operation of energy assets by their
owners.
1 INTRODUCTION 4
On the other hand, Bhattacharya [4] investigates the accuracy of
traditional methods of valuation when cash ows follow a mean-reverting
process, as opposed to the standard Geometric Brownian Motion, and the
ensuing biases in value. Laughton and Jacoby [19][20] and Hasset and
Metcalf [11], among others, discuss several, possibly conicting, inuences of
mean reversion on investment decisions; as they show, neglecting this pattern
may bias investment choices either way. First there is a risk-discounting
eect: mean reversion reduces the long-run uncertainty, and this should
result in a lower risk premium or discount rate for cash ows far into the
future. Thus reversion tends to increase the value of any claim to cash
ows that increase with long-term prices. At the same time, though, lower
uncertainty also tends to reduce directly the value of long-term options of
any type because of the so-called variance eect; this in turn impinges
on the trigger level to invest. But there is also a realized-price eect
whereby investment would be less likely due to the fact that a lower variance
means a lower probability for the cash ows to reach that trigger level.
Robel [25] develops some features of the IGBM process and analyses its
implications on valuation. Insley [14] assumes that timber prices follow
an IGBM process and values forestry investments. Sarkar [27] adopts this
same stochastic process for analysing diverse investment decisions. Weir
[32] deals with the valuation of petroleum lease contracts assuming also an
IGBM process for crude oil prices.
Finally, several papers have analyzed dierent exibility options
concerning the types of inputs or outputs involved, the mode of operation,
or the kind of technology to adopt. First we single out Herbelot [13], who
studies the fulllment of restrictions on oO
2
emissions either through the
purchase of emission permits, or changing the fuel, or deleting polluting
agents in the factory itself.
1
He and Pindyck [12] focus on the exibility to
produce either one of two dierent products; the model can also be applied
to the choice between distinct inputs. On the other hand, Kulatilaka [16]
develops a dynamic model that allows to value the exibility in a exible
manufacturing system with several modes of operation, using a matrix of
transition probabilities between states; in this paper, the importance of
exibility in the design of systems from the viewpoint of both engineers
and competitors is emphasized. Later on, Kulatilaka [18] analyzes the
choice between a exible technology (red by oil or gas) and two inexible
technologies to generate electricity. Some numerical results appear in
Kulatilaka [17], where he normalizes the gas price in terms of the oil price.
A similar problem with two stochastic processes is dealt with in Brekke and
Schieldrop [5]. This is perhaps the closest work to ours. Specically, they
focus on the choice between exible and inexible technologies when fuel
prices are assumed to follow standard geometric Brownian motions; besides
1
A brief summary of this work appears in Dixit and Pindyck [8].
2 THE NGCC AND IGCC TECHNOLOGIES 5
the rm has a perpetual option to invest, and the exible technology involves
no switching costs. In contrast, the rm in our paper faces the choice of
technology assuming that fuel prices display mean reversion, changes in fuel
inputs entail switching costs, and the investment opportunity is available
only for a nite time span (this requires a numerical solution as opposed to
an analytical one).
The paper is organized as follows. In Section 2 we briey introduce the
IGCC and NGCC technologies. Section 3 presents the stochastic model for
fuel prices (IGBM) and its main features. Also in this section, the dierential
equations for the value of a power plant and that for an option to invest in
it are derived. In particular, rst we consider a perpetual option to invest
in an asset whose value depends on fuel price; we obtain a solution in terms
of Kummers conuent hypergeometric function. Then we consider the case
of a nite-lived option; hence the binomial lattices for one and two variables
that we use later in the numerical applications are also shown.
2
The results
for the perpetual option later on serve as a benchmark to verify how the
binomial lattices behave. In Section 4 rst we report some basic parameter
values from an actual power plant that we use in our computations. Then we
value an operating NGCC plant and the option to invest in it. We also value
an operating IGCC plant with switching costs between modes of operation
and the right to invest in this exible technology. Finally we derive the
optimal investment rule when it is possible to choose between the NGCC
and IGCC alternatives. A section with our main ndings concludes.
2 The NGCC and IGCC technologies
2.1 Some features of electric power plants
The production of electricity can be viewed as the exercise of a series of
nested real options to transform a type of energy (gas, oil, coal, or other)
into electric energy. There are two sets of outstanding information. The
rst one has to do with the characteristics of the energy inputs used in the
production process. The second one comprises the operation features of the
electric power plants, among them: the net output, the rate of eciency
(operating heat rate), the costs to start and stop, the xed costs, the
starting and stopping periods, and the physical restrictions that prevent
instantaneous changes between states. These factors determine the wedge
between the prices of the energy consumed and produced. On this basis, at
each instant it is necessary to decide how much electricity to produce and
how, i.e. the possible state changes to realize.
2
The choice of the binomial lattice as a resolution method is due both to its suitability
and acceptance by the industry. See Mun [22].
2.2 Natural Gas Combined Cycle (NGCC) technology
It is based on the employment of two turbines, one of natural gas and another
one of steam.
3
The exhaust gases from the rst one are used to generate the
steam that is used in the second turbine. Thus it consists of a Gas-Air cycle
and a Water-Steam cycle. This system allows for a higher net eciency,
4
close to 55%; future trends aim at reaching net eciencies of 60% in NGCC
plants of 500 Mw.
The advantages of a NGCC Power Plant are:
5
a) Lower emissions of CO
2
, estimated about 350 g/Kwh, which allow an
easier fulllment of the Kyoto protocol;
b) Higher net eciency, between 50% and 60%;
c) Low cost of the investment, about 500 AC/Kw installed;
d) Less consumption of water and space requirements, which allow to
build in a shorter period of time and closer to consumer sites;
e) Lower operation costs, with typical values of 0.35 cents AC/KWh.
In addition, a NGCC power plant can be designed as a base plant or
as a peak plant; in the latter case, it only operates when electricity prices
are high enough, what usually happens during periods of strong growth in
demand.
On the other hand, the disadvantages of a NGCC Power Plant are:
a) The higher cost of the natural gas red in relation to coals;
b) The insecurity concerning gas supplies, since reserves are more
unevenly distributed over the world;
c) The strong rise in the demand for natural gas, which can cause a
consolidation of prices at higher than historical levels.
2.3 Integrated Gasication Combined Cycle (IGCC)
technology
It is based on the transformation of coal into synthesis gas, which is
composed principally of carbon monoxide (CO) and hydrogen (H
2
).
6
This
gas keeps approximately 90% of the heating value of the original coal.
However, the appearance of CO as a by-product demands a special care
with this technology, given the harmful impact of small quantities of this
gas on human health. Besides, the process of gasication increases the costs
of the original investment and those of operating a plant of this type.
The synthesis gas obtained has several applications:
a) Generation of electric energy in IGCC power plants;
3
Also known as Combined Cycle Gas Turbines or CCGT.
4
The net eciency refers to the percentage of the heating value of the fuel that is
transformed into electric energy.
5
Our reference is ELCOGAS [9]: Integrated gasication combined cycle technology:
IGCC and its actual application at the power plant in Puertollano (Spain).
6
According to the following reactions: C + CO
2
!2 CO and C + 1
2
O !CO + 1
2
.
b) Production of hydrogen for diverse uses, like fuel cells; note the
promising future of hydrogen as a fuel in general;
c) As an input to chemical products, like ammonia, for manufacturing
fertilizers;
d) As an input to produce sulphur and sulphuric acid.
After the stage of gasication, it is time to clean the gas by means
of washing processes with water and absorption with dissolvents. This
makes it possible that an IGCC plant has signicantly lower emissions of
oO
2
, O
a
and particles, in relation to those generated in standard coal
power plants. The emissions of CO
2
per Kwh are also lower, but in this
case the improvement derives mainly from the higher net eciency of the
cycle (currently, typical values uctuate around 42%, whith a trend towards
approaching 50%, provided this methodology enhances its design, which is
in its rst steps). Right now, the emissions of CO
2
from an IGCC power
plant (about 725 g/Kwh ) are estimated at 20% lower than those from a
classic coal power plant
7
. However, they are clearly higher than those from
NGCC (around 350 g/Kwh ).
In addition to the gasication plant, the operation of an IGCC power
plant requires another costly element, namely the air separation unit, for
producing oxygen as an oxidizing agent. This unit may represent between
10% and 15% of total investment. Needless to say, the units for gasication,
air separation, and other auxiliary systems raise the initial outlay and imply
higher operation costs.
From the viewpoint of real options, it is necessary to highlight the
following aspects of this technology:
a) The investment in an IGCC plant can be considered as a strategic
investment in a new technology, whose ultimate results will depend on its
nal success or failure;
b) The IGCC power plant is a exible technology concerning the possible
fuels to use; apart from the synthesis gas, it may re oil coke, heavy renery
liquid fuels, natural gas, biomasss, and urban solid waste, among others. In
this way, at each time it is possible to choose the best input combination
according to relative prices. The valuation of this operating exibility
between synthesis gas and natural gas constitutes one of the aims of this
paper.
7
Coal power plants are classied in subcritical, supercritical and ultrasupercritical,
depending on the pressure and the temperature of the steam. The net eciency for coal
power plants rounds about 35% in the supercriticals, and increases with higher investment
costs but also entails an increased hazard due to working at higher temperatures.
3 THE STOCHASTIC MODEL FOR THE FUEL PRICE 8
3 The stochastic model for the fuel price
3.1 The Inhomogeneous Geometric Brownian Motion
(IGBM)
In a model for long-term valuation of energy assets, it is convenient to keep
in mind that prices tend to revert towards levels of equilibrium after an
incidental change.
8
Among the models which display mean reversion, we
have chosen the Inhomogeneous Geometric Brownian Motion (or IGBM)
process:
9
do
t
= /(o
n
o
t
)dt +oo
t
d7
t
, (1)
where:
o
t
: the price of fuel at time t.
o
n
: the level fuel price tends to in the long run.
/: the speed of reversion towards the normal level. It can be computed
as / = log 2,t
12
, where t
12
is the expected half-life, that is the time for the
gap between o
t
and o
n
to halve.
o: the instantaneous volatility of fuel price, which determines the
variance of o
t
at t.
d7
t
: the increment to a standard Wiener process. It is normally
distributed with mean zero and variance dt.
Some of the reasons for our choice are:
a) This model satises the following condition (which seems reasonable):
if the price of one unit of fuel reverts to some mean value, then the price of
two units reverts to twice that same mean value.
b) The term oo
t
d7
t
in the dierential equation precludes, almost surely,
the possibility of negative values.
c) This model admits as a particular solution do
t
= co
t
dt+oo
t
d7
t
when
o
n
= 0 and c = /; therefore it includes Geometric Brownian Motion
(GBM) as a particular case.
d) The expected value in the long run is: 1(o
1
) = o
n
; this is not true
in Schwartz [28], where 1(o
1
) = o
n
(c
2
4k
).
3.2 The fundamental pricing equation
When using binomial lattices below, we will make use of the risk-neutral
valuation principle. The change from an actual process to a risk-neutral one
is accomplished by replacing the drift in the price process (in the GBM case,
8
See, for instance, Dixit and Pindyck [8](pp. 77-78), Pilipovic [24](pp. 63), Ronn
[26](pp. 36), Baker et al. [2](pp. 121), Cortazar and Schwartz [6](pp. 216).
9
This seems to be a well suited model for natural gas futures contracts from
NYMEX (Pilipovic [24] chapter 4). It is also known as Integrated GBM or geometric
Ornstein-Uhlenbeck process. See Bhattacharya [4], Robel [25], Insley [14], Sarkar [27],
Weir [32].
c) with the growth rate in a risk-neutral world, r c, where r is the riskless
interest rate and c denotes the net convenience yield. Note though that the
convenience yield is not constant in a mean-reverting process.
In order to obtain the risk-neutral version of the IGBM process, we
simply discount a risk premium (which, according to the CAPM, is)
joco (2)
to its actual rate of growth. In this expression, j is the correlation between
the returns on the market portfolio and the fuel asset, and c denotes the
market price of risk, which is dened as:
c =
r
A
r
o
A
, (3)
where r
A
is the expected return on the market portfolio and o
A
denotes
its volatility.
Let
^
o
t
denote the risk-neutral version of o
t
; thus
d
^
o
t
= [/(o
n
^
o
t
) joc
^
o
t
]dt +o
^
o
t
d7
t
. (4)
If certain "complete market" assumptions hold, it can be shown that the
value of an investment \ (o, t), which is a function of fuel price and calendar
time, follows the dierential equation:
1
2
o
2
o
2
0
2
\
0o
2
+ [/(o
n
o) joco]
0\
0o
+
0\
0t
r\ +C(o, t) = 0, (5)
where C(o, t) is the instantaneous cash ow generated by the investment.
10
3.3 Valuation of the option to invest
Nex we want to derive the value 1 of an opportunity to invest in a project
whose value \ depends on an asset whose price o follows an IGBM process.
Starting from quation (5) above, in general 1 will depend on o and t.
Since the option confers no cash ow to its owner, its value will satisfy:
1
2
o
2
o
2
0
2
1
0o
2
+ [/(o
n
o) joco]
01
0o
+
01
0t
r1 = 0. (6)
3.3.1 Analytical solution for the perpetual investment option
Let 1 be the value of a perpetual call option on an investment \ which in
turn depends on the value of an asset o following an IGBM process. In this
case, the term 1
t
disappears in (6), which now can be expressed as:
1
2
o
2
o
2
1
00
+ [/(o
n
o) joco] 1
0
r1 = 0. (7)
10
If we equate (v c)
^
o
t
to the coecient of dt in (4), the resulting expression for c is a
function of
^
o
t
.
This equation may be rewritten as:
o
2
1
00
+ (co +,)1
0
1 = 0, (8)
where the following notation has been adopted:
c =
2(/ +joc)
o
2
,
, =
2/o
n
o
2
,
=
2r
o
2
.
In order to nd a solution to this equation, we dene a function /(,o
1
)
by
1(o) =
0
(,o
1
)
0
/(,o
1
), (9)
where
0
and 0 are constants that will be chosen so as to make /() satisfy
a dierential equation with a known solution. As shown in Appendix A,
this function turns out to be:
/(,o
1
) =
1
l(a, /, .) +
2
'(a, /, .), (10)
where l(a, /, .) is Tricomis or second-order hypergeometric function, and
'(a, /, .) is Kummers or rst-order hypergeometric function. Therefore,
the general solution to (9) will be:
1(o) =
0
(,o
1
)
0
(
1
l(a, /, .) +
2
'(a, /, .)). (11)
The boundary conditions will determine whether
1
or
2
in (11) are
zero. In our case, o refers to a fuel input so the rm faces stochastic costs.
An upward evolution in o entails a reduction in prots, so 1() = 0 and
. = 0, then
1
= 0 and the term in Kummers function remains.
11
The
solution is:
1(o) =
n
(,o
1
)
0
'(a, /, .), (12)
with
n
=
0
2
.
12
The constant
n
and the critical value o
below which
it is optimal to invest must be jointly determined by the remaining two
boundary conditions:
a) Value-Matching: 1(o
) = \ (o
) 1(o
),
b) Smooth-Pasting: 1
0
(o
) = \
0
(o
) 1
0
(o
).
11
Due to the fact that l(o, /, 0) = 1 if / 1; this will be shown to hold with our
parameter values below.
12
When a downward evolution of o entails a reduction in prots, so that 1(0) = 0
and : = 1, then
2
= 0 and the term in Tricomis function remains. The solution is
u
(,o
1
)
l(o, /, :) with
u

0
1
, since A(o, /, 1) = 1 and then it must be
2
= 0.
This would be the case of stochastic revenues.
3.3.2 Numerical solution for the non-perpetual option to invest
In this case 1 satises the partial dierential equation (6) which must be
solved by means of numerical procedures. Given the type of the options
involved and the number of sources of uncertainty, the binomial lattice
approach is adopted.
The time horizon T is subdivided into : steps, each of size t = T,:.
Starting from an initial value o
0
, at time i, after , positive increments, the
value of the fuel asset is given by o
0
n
)
d
i)
, where d = 1,n.
Consider an asset whose risk-neutral behaviour follows the stochastic
dierential equation (4):
d
^
o = (/(o
n
^
o) joc
^
o)dt +o
^
od7.
As shown in Appendix B, adopting the transformation A = |:
^
o, upward
movements must be size A = o
_
t; therefore n = c
o
p
t
and d = c
o
p
t
.
The probability of an upward movement at node (i, ,) is
j
&
(i, ,) =
1
2
+
^ j(i, ,)
_
t
2o
, (13)
where:
^ j(i, ,) =
/(o
n
^
o(i, ,))
^
o(i, ,)
joc
1
2
o
2
. (14)
Now consider two assets whose prices are governed by the following
risk-neutral processes:
d
^
o
1
= (/
1
(o
n
1

^
o
1
) j
1
o
1
c
^
o
1
)dt +o
1
^
od7
1
, (15)
d
^
o
2
= (/
2
(o
n
2

^
o
2
) j
2
o
2
c
^
o
2
)dt +o
2
^
od7
2
, (16)
d7
1
d7
2
= j
12
dt. (17)
Dening A
1
= |:
^
o
1
, and A
2
= |:
^
o
2
, Appendix B shows that
A
1
= o
1
_
t, (18)
A
2
= o
2
_
t, (19)
j
&&
=
A
1
A
2
+ A
2
^ j
1
t + A
1
^ j
2
t +jo
1
o
2
t
4A
1
A
2
, (20)
j
&o
=
A
1
A
2
+ A
2
^ j
1
t A
1
^ j
2
t jo
1
o
2
t
4A
1
A
2
, (21)
j
o&
=
A
1
A
2
A
2
^ j
1
t + A
1
^ j
2
t jo
1
o
2
t
4A
1
A
2
, (22)
j
oo
=
A
1
A
2
A
2
^ j
1
t A
1
^ j
2
t +jo
1
o
2
t
4A
1
A
2
. (23)
4 VALUATION OF ALTERNATIVE TECHNOLOGIES 12
In the above expressions, j
&o
stands for the risk-neutral probability of a
downward movement in coal price and a simultaneous upward movement in
gas price at a certain node; similarly for the probabilities j
&&
, j
o&
and j
oo
.
The branches of the lattice have been forced to recombine by taking
constant increments A
1
and A
2
once the step size t has been chosen.
Thus it is easier to implement the model in a computer. Nevertheless the
probabilities change from one node to another by depending on ^ j
1
and ^ j
2
(see expression (14)). Besides, it is necessary that at any time the four
probabilities take on values between zero and one.
4 Valuation of alternative technologies
4.1 Representative values used in the numerical applications
We have used the standard values that appear in Table 1 (ELCOGAS [9]).
Table 1. Basic parameters
Concepts Coal Plant IGCC NGCC Base
Plant Size Mw (P) 500 500 500
Production Factor (%) (FP) 80% 80% 80%
Net Eciency (%) (RDTO) 35% 41% 50.5%
Unit Investment Cost AC/Kw (i) 1,186 1,300 496
O&M cts. AC/Kwh (CVAR) 0.68 0.71 0.32
The Production Factor is the percentage of the total capacity used
on average over the year. Using these data, the heat rate, the plants
consumption of energy, and the total production of electricity can be
computed:
Heat Rate: H1 = 3600,11TO,1, 000, 000, in GJ/Kwh.
13
Investment Cost 1 = 1000 + i + 1, in Euros.
14
Total annual production: = 1000 + 1 + 365 + 24 + 11, in Kwh.
Fuel energy needs: 1 = 1000 + 1 + 365 + 24 + 11 + H1, in GJ/year.
Now with these formulae we estimate the parameters in Table 2.
Table 2. Resulting values
Concepts Coal Plant IGCC NGCC Base
Heat Rate GJ/Kwh 0.0103 0.0088 0.0071
Total Investment (mill AC) (I) 593 650 248
Annual production (mill Kwh)(A) 3,504 3,504 3,504
Fuel Energy (GJ/year) (B) 36,041,143 30,766,829 24,979,010
13
One Kwh amounts to 3,600 KJ, and a GJ (Gigajoules) is a million KJ (Kilojoules).
14
Since power is measured in Mw.
By assumption, the rm is assessing the opportunity to build a baseload
power plant, i.e. one that operates in almost any plausible scenario (as
opposed to a higher-marginal-cost peaking generator, which only operates
when electricity prices are high enough, typically in periods of strong
demand growth).
4.2 Value of an operating NGCC plant
Our rst purpose is to determine the value of a NGCC operating facility.
The revenues are the receipts from the electricity generated, whereas the
costs refer to the initial investment, the average operation costs and those
of the fuel consumed, in this case natural gas. We consider a deterministic
evolution of electricity prices and variable costs, both of which would grow
at a constant rate r
o
.
15
The time-0 value of revenues over a nite number of periods is computed
according to the following formula:
1\ 1 = .1.
(1 c
t(vv
a
)
)
r r
o
, (24)
and variable expenditures amount to:
1\ C
ov
= .C
ov
.
(1 c
t(vv
a
)
)
r r
o
, (25)
where:
= Annual production : 3,504 million Kwh.
1 = Current electricity price : 0.035 AC/Kwh.
16
r
o
= rate of growth of electricity price and variable costs.
r = riskless interest rate: 5%.
C
ov
= unit variable costs: 0.0032 AC/Kwh.
t = Estimated useful life of the power facility upon investment: up to
25 years.
The cost of the initial investment 1 is in our case 248 million euros. Thus:
1\ 1 1\ C
ov
1 = 1, 342, 055, 454 AC. (26)
As for the fuel costs, rst we compute the value (cost) of one fuel unit
consumed per year over the whole life-span of the plant (see expression (57)
15
As a long-lived investment, it is an estimate of the average electricity price during the
assets life that really matters, instead of short-term swings.
16
We have undertaken some preliminary work on the monthly average price in the
Spanish wholesale electricity market (OMEL). According to our results, this price seems to
follow an AR(1) model with strong mean reversion. Therefore we have used the estimated
equilibrium price as a realistic estimate of the deterministic mean electricity price (these
results are available from the authors upon request). Other electricity markets display
similar features; see, for instance, Elliott et al. [10].
in Appendix C). Then multiplying by the annual consumption we get the
present value of fuel costs:
1\ C = 1[
/o
n
(1 c
vt)
r(/ +joc)
+
o
IS
m
I+jo
r +/ +joc
(1 c
(v+I+jo)t
)], (27)
where 1 is the annual fuel energy needed in GJ and o stands for the natural
gas price (AC/GJ). Assuming the additional values:
17
o
n
= 3.25 AC/GJ,
j = 0, c = 0.40, / = 0.25, o = 0.20 and substituting them in the above
formula we obtain the average cost per unit consumed yearly during the
facilitys life: 35.5498 + 3.3315o. Now multiplying the annual unit cost by
annual consumption (1 in Table 2) we get 887, 999, 971 +83, 217, 315o. For
the specic value o = 5.45 AC/GJ, we nally compute:
1\ (GCC) = 1\ 1 1\ C
ov
1 1\ C = 521, 120AC. (28)
4.3 Valuation of the opportunity to invest in a NGCC plant
4.3.1 The perpetual option
Consider the case of a NGCC plant described by the last column in Table 1.
As already seen, the present value of revenues minus the investment outlay
and the present value of variable costs amounts to 1, 342, 055, 454 AC, whereas
the present value of fuel costs is 887, 999, 971+83, 217, 315o. Thus the value
of the investment if realized now is: \ (o)1 = 454, 055, 48383, 217, 315o.
In this case, the boundary conditions would be:
a) Value-Matching: 1(o
) =
n
(,(o
)
1
)
0
'(a, /, ,(o
)
1
) =
454,055,483-83,217,315o
= \ (o
) 1(o
)
b) Smooth-Pasting: 1
0
(o
) =
n
(,(o
)
1
)
0
0(o
)
1
'(a, /, ,(o
)
1
)
oo
b(S
)
2
'(a + 1, / +
1, ,(o
)
1
)
= 83, 217, 315 = \

0
(o
) 1
0
(o
)
By computing c = 12.5, , = 40.625, = 2.5, and 0 = 0.1827, we
derive a and /: a = 0.1827, / = 14.8654.
Thus we have a system of two equations that will allow us to determine
n
and o
. Substituting the value

n
(,(o
)
1
)
0
, from the Value-Matching
condition, in the Smooth-Pasting condition, there results an equation in o
which has as its solution o
= 2.7448.
Next it is easy to determine that
n
= 94, 394, 000 and, nally, that the
value of the option for a gas price o is:
1(o) = 94, 394, 000 + (
40.625
o
)
0.1827
'(0.1827, 14.8654,
40.625
o
).
17
The values for the parameters in the gas price process derive from a cursory look at
NYMEX natural gas futures contracts on October 18th 2004. The price level expected in
the long run corresponds to the futures contract with the longest maturity. Conversely the
spot price has been approximated by the contract with the nearest term. These futures
contract trade in US dollars per 10,000 million British thermal units.
In our case, with o = 5.45, initially the option value is 153, 870, 000 AC,
against a 1\ = 521, 120 AC; thus it is optimal to wait.
If there were no other option but to invest now or never, the hurdle
point would be \ (o
) = 1(o
), whence we get o
= 5.4563. However,
with a perpetual option it is preferable to wait, since in principle and in
the long run natural gas price is going to decrease and uctuate around a
level o
n
= 3.25, and then keep on waiting until it reaches o
= 2.7448 or
below this value, so that the option value be equal to the net value of the
investment. When the option may be exercised only during a nite period,
the threshold o
will take on a value between 5.4563 and 2.7448.

Appendix D deals with the perpetual investment option in the
deterministic case. It also includes some sensitivity analysis with respect
to changes in o, / and o
n
.
4.3.2 The non-perpetual option
Now we want to determine the value of an investment option and the
optimal investment rule in a NGCC facility when the opportunity is available
between time 0 and T.
The costs of the initial investment are 1c
v
b
t
, with 0 _ t _ T, where 1
is the initial investment at time t = 0 and r
b
is its rate of growth (both
electricity price and variable costs are now supposed to remain constant).
At the nal moment t = T, there is no other option but to invest right
then or not to invest. The decision to go ahead with the investment is taken
if the present value of revenues exceeds that of costs:
1\ = 1\ (1cc:nc:) 1\ (1rjc:ditnrc:) 0.
A binomial lattice is arranged with the following values in the nal nodes:
\ = :ar(1\, 0).
At previous moments, that is, when 0 _ t < T, depending on the current
fuel price, we compute the present value of exercising the option to invest
(1\ ), and compare it with the value of keeping the option alive, choosing
the maximum between them:
\ = 'ar(1\, c
vt
(j
&
\
+
+j
o
\
)).
The lattice is solved backwards, which provides the time-0 value. If
we compare this value with that of an investment made at the outset, the
dierence will be the value of the option to wait. Logically this options
value will always be nonnegative.
By changing the initial value of the fuel unit cost it is possible to
determine the fuel price at which the option value switches from positive to
zero. This will be the optimal exercise price at t = 0. Similarly, arranging
a binomial lattice for the investment opportunity with maturity t < T and
changing the fuel price, the optimal exercise price for intermediate moments
is determined.
At the nal date, since there is no chance for further delay, investment
is realized only if 1\ 0. The optimal point to invest will be found
by computing the gas price for which 1\ = 0; in our case, this value is
o
0
= 5.4563. In the opposite case of an unlimited possibility to defer, when
r
o
= r
b
= 0, it must be o
1
= 2.7448, which comes from the analytical
solution for the perpetual option. These results appear in Table 3. They
show a convergence towards those of the perpetual option as the maturity
of the investment opportunity increases.
18
Table 3. Trigger price o
with nite time to maturity

Term r
o
= 0, r
b
= 0 r
o
= 0, r
b
= 0.025 r
o
= 0, r
b
= 0.05
0 5.4563 5.4563 5.4563
1
2
3.3268 3.5587 3.7823
1 3.2200 3.4417 3.6503
2 3.0864 3.3035 3.5107
3 3.0040 3.2250 3.4394
4 2.9480 3.1751 3.3982
5 2.9079 3.1413 3.3731
6 2.8782 3.1179 3.3575
7 2.8557 3.1012 3.3481
8 2.8386 3.0893 3.3423
9 2.8253 3.0808 3.3392
10 2.8151 3.0746 3.3378
2.7448 - -
The value of the option to invest increases with the options maturity. In
order to be exercised optimally, a longer-lived option requires a lower critical
price for the fuel resource. It can also be observed that a higher r
b
, ceteris
paribus, quickens the time to invest: the higher the investment growth rate,
the less stringent the hurdle to invest (as shown up by a higher o
). When
the time to maturity is zero, though, there is no inuence from the rate of
growth of the initial investment.
Next we analyze the optimal choice between investing or waiting, when
the investment opportunity is available for ve years, depending on the
initial fuel price.
18
Numerical results in Table 3 correspond to a setting with 1200 steps, irrespective of
the options time to maturity. Take, for example, the option to invest in the next 5 years
(then one month would comprise 20 time steps). When v
a
= v
b
= 0, it is optimal to invest
in a NGCC plant if gas price falls to 2.9079. With 150 steps (instead of 1,200), the trigger
price turns out to be 2.9394 AC/GJ, and with 10,000 time steps it is 2.8963 AC/GJ. Thus
the dierences in the critical price do not seem to be large (around 1% or less).
Table 4. NPV and option values with T = 5 years
o
0
NPV(AC) Option value Max(NPV,Option) Optimal decision
5.45 521,120 119,170,000 119,170,000 Wait
5.00 37,969,000 129,040,000 129,040,000 Wait
4.50 79,578,000 141,640,000 141,640,000 Wait
4.00 121,190,000 156,820,000 156,820,000 Wait
3.50 162,790,000 176,420,000 176,420,000 Wait
3.00 204,400,000 205,010,000 205,010,000 Wait
2.9079 212,070,000 212,070,000 212,070,000 Indierent
2.50 246,010,000 245,900,000 246,010,000 Invest
2.00 287,620,000 287,450,000 287,620,000 Invest
In principle, a lower fuel price ceteris paribus will render the power
plant more valuable; this in turn will increase the value of the option to
invest. Thus it is not obvious whether a cheaper natural gas will hasten the
investment decision or not. As shown in Table 4, when o
0
= 5.45, the NPV
is very low and the option to invest is worth more than 119 million euros.
As the value of o
0
decreases, the investment option increases in value but
less than the NPV, with the equality being reached when o
0
= 2.9079. For
lower gas prices, it is preferable to invest immediately.
4.4 Valuation of an operating IGCC plant
Now we must compute the value of an operating IGCC power station, both
right upon the initial outlay and at any moment along its useful life to derive
its remaining value. We accomplish this by means of two two-dimensional
binomial lattices
19
which refer to initial states consuming either coal or
natural gas, respectively.
At the end of the plants useful life its value is zero, regardless of whether
that instant has been reached consuming coal or natural gas:
\c = \q = 0,
where \c and \q stand for the plants (gross) value according to the nodes
in coal and gas lattices, respectively.
At earlier times t we compute, for a time interval t, the prots by
mode of operation, which are determined as the dierence between electricity
revenues and the sum of variable plus fuel costs:
c
= .1.c
v
a
t
(1 c
t(vv
a
)
)
r r
o
1
c
to
c
.C
ov
c
.c
v
a
t
(1 c
t(vv
a
)
)
r r
o
,
(29)
19
Given that the rm faces two stochastic fuel prices, there are two sources of risk and
two-dimensional binomial lattices are needed.
j
= .1.c
v
a
t
(1 c
t(vv
a
)
)
r r
o
1
j
to
j
.C
ov
g
.c
v
a
t
(1 c
t(vv
a
)
)
r r
o
,
where:
c
: Net prots from operating with coal.
j
: Net prots from operating with natural gas.
o
c
: current coal price.
o
j
: current natural gas price.
.1.c
v
a
t
(1c
t(rr
a
)
)
vv
a
: value at time t of revenues from electricity over
the period t.
.C
ov
.c
v
a
t
(1c
t(rr
a
)
)
vv
a
: value at time t of variable costs incurred over
t.
1
c
: the coal energy needed per year in GJ.
1
j
: the natural gas energy needed per year in GJ.
1
c
to
c
: Costs of coal consumed during t.
1
j
to
j
: Costs of natural gas consumed during t.
1(c q) : Switching cost from coal to gas.
1(q c) : Switching cost from gas to coal.
If initially the IGCC plant was consuming coal, the best of two options
is chosen:
20
a) continue: the present value of the coal lattice is obtained, plus the
prots from operating in coal-mode at that instant.
b) switch: the present value of the gas lattice is obtained, plus the prots
from operating in gas-mode at that instant, minus the costs to switching
from coal to gas, 1(c q).
Thus the binomial lattices will take on the following values:
21
\c = 'ar(
c
+c
vt
(j
&&
\c
++
+j
&o
\c
+
j
o&
\c
+
+j
oo
\c
),
j
1(c q)+
+c
vt
(j
&&
\q
++
+j
&o
\q
+
j
o&
\q
+
+j
oo
\q
)). (30)
Similary, when the initial state corresponds to operating with natural
gas, we would compute:
\q = 'ar(
c
1(q c)+c
vt
(j
&&
\c
++
+j
&o
\c
+
j
o&
\c
+
+j
oo
\c
),
j
+c
vt
(j
&&
\q
++
+j
&o
\q
+
j
o&
\q
+
+j
oo
\q
)). (31)
20
We have not considered the option not to operate, though it could be taken into
account easily. It could be included by a third lattice, corresponding to an idle initial
state. At every time we should maximize over three possible values, taking into account
the switching costs between states. If we denote the idle state by j, in this case there could
be a stopping cost: 1(c !j) or 1(j !j), and a restarting cost: 1(j !c) or 1(j !j). If
restarting costs were very high, stopping could amount to abandone.
21
We follow a similar procedure to Trigeorgis [31], pp. 177-184 (the case with switching
costs).
Finally, at time zero the optimal initial mode of operation is chosen by:
'ar(\c, \q).
In this way, we have derived the value of a exible plant in operation.
In this computation, for a plant operating for some time, the cost of the
initial investment plays no role, but it could be included at the outset in
order to compare this outlay with the present value of expected prots.
Table 5 shows the parameter values adopted in the base case.
22
Some of
them are taken from Table 1 but are repeated here for convenience.
Table 5. An IGCC power plant: base case
Concepts Coal Mode Gas Mode
Plant Size Mw (P) 500 500
Production Factor(FP) 80% 80%
Net Eciency(%) (RDTO) 41.0% 50.5%
Unit Investment cost AC/Kw (i) 1,300 1,300
Operation cost (ACcents/Kwh) (CVAR) 0.71 0.32
Fuel price (AC/GJ) 1.90 5.45
Reversion value o
n
(AC/GJ) 1.40 3.25
Reversion speed (/) 0.125 0.25
Plants useful life (years)(t) 25 25
Risk-free interest rate (r) 0.05 0.05
Market price of risk (c) 0.40 0.40
Volatility (o) 0.05 0.20
Correlation with the market (j
1
, j
2
) 0 0
Correlation between fuels (j
12
) 0.15 0.15
Investment cost rate of growth (r
b
) 0 0
Electricity price rate of growth (r
o
) 0 0
Switching costs (AC) 20,000 20,000
Making the computations with a lattice of 300 steps (one for each month
of useful life), Table 6 shows the ensuing results, as a function of switching
costs.
23
22
Parameter values for coal and gas price processes, as well as their correlation
coecient, have been computed from yearly average prices gathered by the US Energy
Information Administration. Note that these prices are in US dollars per million Btu, so
they must be turned into AC/GJ.
23
As mentioned in the text, gures in Table 6 correspond to a setting with 300 steps,
regardless of switching costs. As the number of timesteps is raised the scope for seizing
the palnts exibility increases. Take, for instance, switching costs of 20.000 AC; the plants
net value amounts to 52,534,000 AC. If we consider 75 timesteps the net value falls to
47,662,000 AC, whereas with 1200 steps this value becomes 53,693,000 AC. Nonetheless it
does not seem very realistic to allow for very frequent changes in the mode of operation
(say, daily or weekly). That is why we have chosen a monthly timestep.
Table 6. Gross and net value (AC) of an IGCC Plant
Switching costs (AC) Plants value Plants value - Initial investment
0 702,662,000 52,662,000
10,000 702,598,000 52,598,000
20,000 702,534,000 52,534,000
50,000 702,345,000 52,345,000
100,000 702,129,000 52,129,000
1,000,000 700,049,000 50,049,000
691,987,000 41,987,000
When there are no switching costs, the value of the plant exceeds the
initial investment (650,000,000 AC) by 52,662,000 AC. Thus it is worth an
8.10% more than the amount disbursed. As switching costs swell, the plants
value drops.
Comparing the value in each case with that of innite switching costs,
the dierence shows the value of exibility; this amounts to 10,675,000 AC in
the absence of switching costs, just 1.5% of the initial investment. Note that
exibility in the IGCC plant may be valuable because of reasons dierent
from harnessing at each instant the best fuel option. For instance, it may
be due to failures in elements necessary to operate in coal-mode, but that
do not prevent the plant from operating in gas-mode and avert the total
stopping of the facility. The same could happen in the case of problems
concerning supplies of a certain kind of fuel.
In the case of innite switching costs, in which operation turns out to be
only in coal-mode, the value of the plant changes with the number of steps
in the lattices. With 3,000 steps we reach a value (net of investment cost)
of 43,353,000 AC, a gure which is very close to the 43,594,000 AC obtained
by following an analytical procedure akin to that for a natural gas plant.
24
The plants value as a function of coal and natural gas prices appears in
Figure 1. It can be observed that the investment value drops as the price
of either fuel rises. Also, for low gas prices, the value of the plant decreases
smoothly when coal price swells, since this is not the preferred fuel resource.
However, for high gas prices, the plant burns mainly coal; if this gets dearer,
an abrupt fall in value ensues.
Table 7 shows the (gross) value of the plant as a function of the remaining
life, for the base case with switching costs of 20,000 AC, without taking into
account the initial investment of 650,000,000 AC. For the sake of consistence,
we have used one step per month again.
25
24
With innite switching costs, there is no scope for exibility and the cheapest fuel
resource is used exclusively. Thus the above formulas for the NGCC plant apply, but now
they refer to coal.
25
Concerning the convergence of these results, for illustrative purposes let us consider a
plant with 10 years to closure. With 1012=120 monthly timesteps, the gross value of the
plant (v
a
= 0.00) is 361,090,000 AC. Again, the plants value increses with the number of
Figure 1: Gross value (AC) of an IGCC plant (a=0.00, t=25).
Table 7. Value (AC) of an operating IGCC plant as a function of the
growth rate of electricity price and variable cost (r
o
)
Remaining life Plant value r
o
= 0.00 Plant value r
o
= 0.03
25 years 702,534,000 1,245,700,000
20 years 613,835,000 999,120,000
15 years 501,490,000 742,186,000
10 years 361,090,000 479,990,000
5 years 191,020,000 223,980,000
4 years 153,950,000 175,460,000
3 years 116,150,000 128,500,000
2 years 77,806,000 83,409,000
1 year 39,044,000 40,477,000
0 year 0 0
Whatever the rate of growth of the electricity output (and variable costs),
r
o
, the plants value diminishes as its life-span comes to an end. Note also
that at least two factors are at work here. For concreteness, consider the
plants value with 1 and 2 years before closure. Clearly the reversion eect
is stronger over 2 years than over 1 year; thus one would expect the plants
value with 2 years to be more than double that with 1 year to operate. Yet
the inuence of the discount rate r = 0.05 pushes against this trend. For
steps but the increase is not relatively large: with 1,500 timesteps it jumps to 362,050,000
AC.
constant electricity prices (r
o
= 0), the eect of time discounting prevails
since 77,806,000 euros is less than 239,044,000 euros. This is not the case,
though, with rising electricity prices (r
o
= 0.03), so now the reversion eect
more than osets the discount eect.
4.5 Valuation of the opportunity to invest in an IGCC plant
Let us assume that the investment opportunity is available from time 0 to
T (the non-perpetual option). In this case, the procedure is very similar
to that for the optimal timing to invest in a NGCC plant. Nonetheless,
the value of an operating plant must be determined at each node of the
two-dimensional lattice from another two-dimensional lattice which takes as
a starting point the prices at that node.
26
At the nal date, the choice must be made between investing then if the
plants value is positive or not to invest:
\ = :ar(1\
ijcc
, 0).
With switching costs of 20,000 AC as in the base case, Table 8 shows
combinations of coal and natural gas prices that imply a zero value (that is,
the plant value matches initial outlay) at maturity.
Table 8. IGCC critical curve at t = T
Gas price (AC/GJ) Coal price (AC/GJ)
2.1410
5.4563 2.2325
5.45 2.2327
5.00 2.2446
4.50 2.2642
4.00 2.2974
3.50 2.3684
3.25 2.4485
3.00 2.5802
2.50 3.0682
2.00 4.0610
1.50 6.2646
1.00 18.9226
0.9897
26
Note that the rm must choose the optimal time to invest from time 0 to T. This
means that at every moment it must compare the continuation value (i.e. that of the
option to invest when kept unexercised) and the value of an immediate investment. Since
the rm can decide to invest at any time given current fuel prices, the plants useful
life can start at any moment at the prevailing fuel prices. This implies that the above
task of valuing an operating IGCC power plant now must be solved at every node of the
two-dimensional binomial tree.
If the IGCC plant is to be worthy for a very high coal price, it is necessary
that natural gas prices remain below 0.9897 AC/GJ. This is due to the fact
that the reversion process pushes gas prices towards 3.25 AC/GJ. However,
if gas price were to grow arbitrarily high, the plants value would reach zero
for a coal price of 2.1410 AC/GJ, which is above its reversion value (o
n
=
1.40 AC/GJ). For lower coal prices, its value would even switch to positive.
This seems reasonable since the IGCC plant is mainly designed to operate
with coal.
At previous moments, the best of the two options (to invest or to
continue) has to be chosen:
\ = 'ar(1\
ijcc
, c
vt
(j
&&
\
++
+j
&o
\
+
j
o&
\
+
+j
oo
\
)). (32)
At t = 0, the value obtained from the lattice is compared with that of an
investment realized right then. The dierence is the value of the option to
wait.
By using a lattice with quarterly steps for the option to invest, and one
with monthly steps to value the plant, we get the valuations in Table 9 for
the base case, as a function of the time to maturity of the investment option:
Table 9. NPV and option values (IGCC plant)
Term (years) NPV (AC) Option value Option value - Plant NPV
5 52,534,000 76,398,000 23,864,000
4 52,534,000 74,179,000 21,645,000
3 52,534,000 71,048,000 18,514,000
2 52,534,000 66,651,000 14,117,000
1 52,534,000 60,592,000 8,058,000
0.5 52,534,000 56,835,000 4,301,000
0 52,534,000 52,534,000 0
The second column refers to the plant value under the assumption of a
now or never investment in the exible technology. It includes the value
of the plants exibility.
The value of the option to wait increases with its maturity, given the
starting point of the prices (both above their reversion levels). The highest
yearly increase takes place in the rst period (8, 058, 000 AC); henceforth that
increase is much lower since the eect of reversion is stronger in the initial
periods.
27
The optimal investment rule in an IGCC technology can be derived
following a procedure akin to that used for the NGCC technology in the base
case. Nonetheless, in this case and at each time, we will have to compute
27
With t
1=2
=
ln(2)
k
one would guess that gas price will change from 5.45 AC/GJ to
4.35 AC/GJ in 2.77 years time. On the other hand, the expected price for coal 5.55 years
from now would be 1.65 AC/GJ. The value of t
1=2
results from solving: o
0
(
S
0
S
m
2
) =
o
m
+ (o
0
o
m
)c
kt
1=2
.
the combinations of coal price and gas price for which the option to wait is
worthless.
At any t, a range of initial prices for coal is chosen; then, for each one of
them, we compute the natural gas price for which the option to wait turns
from positive to zero. For an option to wait up to two years, we get Table
10. Again, the higher the price of one fuel, the cheaper the other one. That
is, since both coal and gas are fuel resources, there must be a trade-o in
their prices for the options value to stabilise at a certain level (in this case,
zero).
Table 10. Critical values with option to wait up to 2 years (IGCC)
Gas price Coal price
1.57
5.45 1.56
5.00 1.56
4.50 1.56
4.00 1.56
3.50 1.56
3.25 1.57
3.00 1.57
2.50 1.59
2.25 1.85
2.00 2.98
1.50 5.15
0.96
These results are shown in Figure 2. It can be observed that the new
locus has shifted downwards and to the left, in relation to the case in which
there is no option to wait (Table 8). In other words, it makes sense to give
up (kill) the option to wait if fuel prices are now relatively lower than
before but not otherwise. The upper locus divides the price space into two
regions; above, the best decision is not to invest, and below it is optimal to
invest. Similarly, above the lower locus the rm should wait, but it should
invest immediately if fuel prices happened to fall below this locus.
Now let us consider for a moment the surface in Figure 1. Fixing natural
gas price at o
j
= 5.00 AC/GJ, the resulting graphic would be a downward
sloping curve in the plants value / coal price plane. Subtracting from these
gross values the investment disbursement, and restricting coal prices to the
range from 1.4 AC/GJ to 1.9 AC/GJ, the lower locus in Figure 3 arises. For
convenience, in addition to the net value of the plant, the value of the option
to invest has also been drawn. It can be observed that optimal exercise of
the option will take place as soon as coal price falls to 1.56 AC/GJ. If this is
higher, it will be better to wait.
Figure 2: Optimal divide between invest / not invest (upper locus) and
invest / wait (lower locus) in an IGCC power plant without and with an
option to wait.
Figure 3: Net value of the IGCC plant (for o
j
= 5.00 AC/GJ) and value of
the option to invest with two years to maturity, both as a function of coal
price.
4.6 Valuation of the opportunity to invest in NGCC or
IGCC
Up to now we have considered both the exible and the inexible
technologies in isolation. When there is an opportunity to invest in either
one of the two technologies, at each moment we face the choice:
a) to invest in the inexible technology (NGCC),
b) to invest in the exible technology (IGCC),
c) to wait and at maturity give up the investment.
At the nal date, since there is no remaining option, the best alternative
among the three available ones is chosen:
\ = :ar(1\
ijcc
, 1\
ajcc
, 0),
where the value 1\
ijcc
, at each point in the binomial lattice, is computed
by means of a two-dimensional binomial lattice with the fuel prices at that
node.
If, at time T, the only possibility is to invest in the NGCC technology,
the investment is realized whenever the natural gas price is lower than 5.4563
AC/GJ; see Table 3. Similarly, if, at time T, the only alternative is to invest
in the IGCC technology, the plant is built when the pairs of gas price and
coal price lay below the curve resulting from Table 8. Now Figure 4 shows
both decision rules, but it must be remembered that, in this case, it is not
possible to choose the best possibility. Thus, for natural gas prices o
j
above
5.45 AC/GJ, it does not pay to invest in a NGCC plant. Concerning the IGCC
facility, it is optimal to invest for pairs of fuel prices below the decreasing
locus, but not otherwise. Note from Table 8 that this locus intersects the
vertical border at a coal price o
c
= 2.23 AC/GJ.
Now assume that at time T it is possible to choose between the two
alternatives (Figure 5). Clearly, if both fuel prices are relatively high, none
of the technologies will be adopted and there will be no new investment
in these power plants. There are also multiple pairs (o
j
, o
c
) such that
the value of the investment is positive for the two plants; consequently the
investment with the highest value will be chosen. Thus, given a high coal
price, if o
j
drops enough the NGCC will become the technology of choice.
Alternatively, given a high gas price, if o
c
falls enough the IGCC technology
will be preferred. This area will be divided into two by a line starting
at the point (o
j
= 5.4563, o
c
= 2.2325) and pointing towards the origin,
along which there is indierence between investing in IGCC and investing
in NGCC.
At previous moments, the choice is:
\ = :ar(1\
ijcc
, 1\
ajcc
, c
vt
(j
&&
\
++
+j
&o
\
+
j
o&
\
+
+j
oo
\
)).
Figure 4: Decision areas (at time T) when each technology is considered in
isolation.
Figure 5: Investment / Continuation areas (at time T) when choosing
between the two technologies.
Figure 6: Investment / Continuation areas when both technologies are on
oer and there is an option to wait up to two years.
This computing procedure is iteratively followed until the initial value is
obtained. At that instant, the NGCC technology will be adopted if \ =
1\
ajcc
; similarly, the IGCC technology is chosen if \ = 1\
ijcc
. If there
is no investment at t = 0, this means that the best option is to wait.
The points over the optimal exercise curve are those for which the value
of the option to wait changes from positive to zero. In principle, there may
be two curves, one for the IGCC plant and another one for the NGCC plant.
See Figure 6 for an option to invest in either technology with two years to
maturity. It can be observed that:
a) In order to invest, prices must be rather lower than those when there
is no option to wait. Thus the new locus for the NGCC moves leftwards
from the vertical line at o
j
= 5.45 AC/GJ before; and the new locus for the
IGCC moves downwards from the at line at o
c
= 2.23 AC/GJ. The reversion
eect, given the initial prices, promotes this behaviour.
b) For a very high natural gas price, there will be investment in an IGCC
plant if coal price falls below 1.57 AC/GJ; this is the same that we computed
for the IGCC investment option when this was the only technology available
(Table 10).
c) Similarly, for a very high coal price, there will be investment in a
NGCC plant if gas price is less than 3.17 AC/GJ. This result would apply
as an option to waitt for two years in a NGCC plant with a lattice of 8
quarterly steps, the same step size used in the option to invest with the two
5 CONCLUDING REMARKS 29
technologies on oer.
d) For fuel prices close to the iso-value line between immediate
investment in NGCC and IGCC, the best choice is just to wait and see
how uncertainty unfolds. The waiting zone expands into the regions of
immediate investment by driving a wedge along the indierence line (at T)
between NGCC and IGCC.
The shape of the three zones in Figure 6 somehow resembles that in
Brekke and Schieldrop [5], which is derived as the analytic result of a
perpetual option to invest. In our case the solution is numerical because
the option to invest is nite-lived.
5 Concluding remarks
Many investments in the energy sector can be conveniently valued as real
options. Frequently appearing features are the operating exibility and the
possibility to delay the investment or even not to invest at the nal moment.
Special attention in the valuation must be paid to the nature of the stochastic
processes that govern the underlying variables.
In this paper we have dealt with the choice between competing
technologies for producing a certain output (electricity). In particular, we
have analyzed the valuation of the opportunity to invest in an IGCC power
plant, as opposed to the alternative of an NGCC power plant, according to
the current prices of natural gas and coal when these follow a mean-reverting
process, namely an IGBM. As a reference point we also have computed the
value of a perpetual option to invest. The IGCC power plant has been
valued with switching costs and choice of the optimal mode of operation;
actual parameters from an operating plant have been used.
First we have computed the value of an operating NGCC plant. This
is relatively easy since there is no special exibility in its usage. Then the
value of a perpetual option to invest in it has been estimated. It serves as
a limiting case or reference point for the nite-lived option. This has been
valued by means of a binomial lattice for dierent maturities and growth
rates of electricity price and investment outlay. The optimal investment rule
for a given term as a function of natural gas price has also been analyzed.
Second we have valued an IGCC plant in operation using two
two-dimensional lattices, depending on whether initially the plant burns
coal or natural gas. The value of the plant has been computed as a function
of switching costs and for dierent useful life-spans with constant or growing
electricity prices. Next the non-perpetual option to invest in an IGCC
plant has been considered, assuming again that this is the only technology
available. In this case, an optimal locus of fuel prices arises above which it
is optimal to wait. As could be expected, the longer the options maturity
the closer the locus is to the origin in the prices space.
A ANALYTICAL SOLUTIONOF THE PERPETUAL INVESTMENT OPTION30
Third we have assumed that both technologies are on oer. Our results
show the inuence of the mean-reverting process on the critical values when
current fuel prices are above their level expected in the long run. The value
of the operating exibility in the IGCC power plant seems to be low, because
it is designed to function mainly with coal. We show that prior to options
maturity there is a small region in the prices space in which it is optimal to
wait whereas at maturity it was optimal to invest, since the values of both
technologies are very close; outside it, optimal decisions are clear-cut.
A Analytical solution of the perpetual investment
option
In order to nd a solution to the ordinary dierential equation in 1, we
dene a function /(,o
1
) by
1(o) =
0
(,o
1
)
0
/(,o
1
). (33)
where
0
and 0 are constants that will be chosen so as to make /() satisfy a
dierential equation with a known solution. The rst and second derivatives,
divided by
0
,
0
, are:
1
0
(o)
0
,
0
= (0)o
01
/(,o
1
) +o
02
/
0
(,o
1
)(,),
1
00
(o)
0
,
0
= 0(0 + 1)o
02
/(,o
1
) + (0)o
03
/
0
(,o
1
)(,) +
+o
03
(0 2)(,)/
0
(,o
1
) +o
04
/
00
(,o
1
),
2
.
Substituting these expressions in (8) and simplifying we get:
o
0
/(,o
1
) (0(0 + 1) c0 ) +o
01
o
1
,
2
/
00
(,o
1
) +
+/
0
(,o
1
)(,0 + (0 + 2), c, o
1
,
2
) /(,o
1
)0,
= 0
For this equality to hold, rst it must be:
0(0 + 1) 0c = 0
2
+0(1 c) = 0. (34)
This equation allows to determine the positive value of 0, since the remaining
terms are known constants.
Once the value of 0 has been obtained, the remainder of the equation is:
(,o
1
)/
00
(,o
1
) +/
0
(,o
1
)(20 + 2 c ,o
1
) 0/(,o
1
) = 0.
A ANALYTICAL SOLUTIONOF THE PERPETUAL INVESTMENT OPTION31
This is Kummers Dierential Equation,
28
where: a = 0, / = 20 + 2 c,
and . = (,o
1
). The general solution to this equation has the form:
/(,o
1
) =
1
l(a, /, .) +
2
'(a, /, .), (35)
where l(a, /, .) is Tricomis or second-order hypergeometric function, and
'(a, /, .) is Kummers or rst-order hypergeometric function.
Therefore, the general solution to (33) will be:
1(o) =
0
(,o
1
)
0
(
1
l(a, /, .) +
2
'(a, /, .)). (36)
The second-order hypergeometric function has the following representation:
l(a, /, .) =
(1 /)
(1 +a /)
'(a, /, .) +
(/ 1)
(a).
(b1)
'(1 +a /, 2 /, .), (37)
where (.) is the gamma function and M(a,b,z) is Kummers function, whose
value is given by:
'(a, /, .) = 1 +
a
/
. +
a(a + 1)
/(/ + 1)
.
2
2!
+
a(a + 1)(a + 2)
/(/ + 1)(/ + 2)
.
3
3!
+. . . (38)
The derivatives of Kummers function have the following properties:
0'(a, /, .)
0.
=
a
/
'(a + 1, / + 1, .),
0
2
'(a, /, .)
0.
2
=
a(a + 1)
/(/ + 1)
'(a + 2, / + 2, .).
The derivatives of Tricomis function satisfy:
0l(a, /, .)
0.
= al(a + 1, / + 1, .),
0
2
l(a, /, .)
0.
2
= a(a + 1)l(a + 2, / + 2, .).
28
See Abramowitz and Stegun [1], equation 13.1.1.
B BINOMIAL LATTICES FOR IGBM VARIABLES 32
B Binomial lattices for IGBM variables
B.1 Binomial lattice for a risk-neutral IGBM variable
The time horizon T is subdivided in : steps, each of size t = T,:. Starting
from an initial value o
0
, at time i, after , positive increments, the value of
the fuel asset is given by o
0
n
)
d
i)
, where d = 1,n.
Consider an asset whose risk-neutral behaviour follows the dierential
equation:
d
^
o = (/(o
n
^
o) joc
^
o)dt +o
^
od7. (39)
This can also be written as:
d
^
o =
/(o
n
^
o)
^
o
joc
!
^
odt +o
^
od7 = j
^
odt +o
^
od7. (40)
Since it is usually easier to work with the processes for the natural logarithms
of asset prices, we carry out the following transformation: A = |:
^
o. Thus
A
c
= 1,
^
o, A
cc
= 1,
^
o
2
, A
t
= 0, and by Itos Lemma:
dA = (
/(o
n
^
o)
^
o
joc
1
2
o
2
)dt +od7 = ^ jdt +od7, (41)
where ^ j = /(o
n
^
o),
^
o joc
1
2
o
2
depends at each moment on the asset
value
^
o.
Following Euler-Maruyamas discretization, the probabilities of upward
and downward movements must satisfy three conditions:
a) j
&
+j
o
= 1.
b) 1(A) = j
&
A j
o
A =
I(S
m
^
S)
^
S
joc
1
2
o
2
t = ^ jt. The
aim is to equate the rst moment of the binomial lattice (j
&
A j
o
A)
to the rst moment of the risk-neutral underlying variable (^ jt).
c) 1(A
2
) = j
&
A
2
+ j
o
A
2
= o
2
t + ^ j
2
(t)
2
. In this case the
equality refers to the second moments. For small values of t, we have
1(A
2
) - o
2
t.
From a) and b) we obtain the probabilities, which can be dierent at
each point of the lattice (because ^ j depends on
^
o, which may vary from
node to node):
j
&
=
1
2
+
^ jt
2A
. (42)
From c) there results A = o
_
t; therefore, n = c
o
p
t
. The
probability of an upward movement at point (i, ,) is:
j
&
(i, ,) =
1
2
+
^ j(i, ,)
_
t
2o
, (43)
where:
^ j(i, ,) =
/(o
n
^
o(i, ,))
^
o(i, ,)
joc
1
2
o
2
. (44)
B BINOMIAL LATTICES FOR IGBM VARIABLES 33
B.2 Binomial lattice for two risk-neutral IGBM variables
Consider two assets whose prices are governed by the following risk-neutral
processes:
d
^
o
1
= (/
1
(o
n
1

^
o
1
) j
1
o
1
c
^
o
1
)dt +o
1
^
od7
1
, (45)
d
^
o
2
= (/
2
(o
n
2

^
o
2
) j
2
o
2
c
^
o
2
)dt +o
2
^
od7
2
, (46)
d7
1
d7
2
= j
12
dt, (47)
where j
1
and j
2
denote the correlations of their respective returns with
those of the market portfolio. Adopting the transformations A
1
= |:
^
o
1
,
A
2
= |:
^
o
2
, and applying Itos Lemma:
dA
1
=
/
1
(o
n
1

^
o
1
)
^
o
1
j
1
o
1
c
1
2
o
2
1
!
dt +o
1
d7
1
= ^ j
1
dt +o
1
d7
1
, (48)
dA
2
=
/
2
(o
n
2

^
o
2
)
^
o
2
j
2
o
2
c
1
2
o
2
2
!
dt +o
2
d7
2
= ^ j
2
dt +o
2
d7
2
. (49)
Now it is necessary to solve a system of six equations:
a) j
&&
+j
&o
+j
o&
+j
oo
= 1. The probabilities must sum to one.
b) 1(A
1
) = (j
&&
+ j
&o
)A
1
(j
o&
+ j
oo
)A
1
= ^ j
1
t. This is the
expected value of the increment in A
1
.
c) 1(A
2
1
) = (j
&&
+j
&o
)A
2
1
+(j
o&
+j
oo
)A
2
1
= o
2
1
t + ^ j
1
2
t
2
. This
is the expected value of the second non-central moment of the increment in
A
1
.
d) 1(A
2
) = (j
&&
+ j
o&
)A
2
(j
&o
+ j
oo
)A
2
= ^ j
2
t. This is the
expected value of the increment in A
2
.
e) 1(A
2
2
) = (j
&&
+j
o&
)A
2
2
+(j
&o
+j
oo
)A
2
2
= o
2
2
t + ^ j
2
2
t
2
. This
is the expected value of the second non-central moment of the increment in
A
2
.
f) 1(A
1
A
2
) = (j
&&
j
&o
j
o&
+j
oo
)A
1
A
2
= jo
1
o
2
t+ ^ j
1
^ j
2
t
2
.
This is the expected value of the product A
1
A
2
, which amounts to
satisfying the correlation condition.
The solution to this system of equations, ignoring the elements in t
2
,
is:
29
A
1
= o
1
_
t, (50)
A
2
= o
2
_
t, (51)
j
&&
=
A
1
A
2
+ A
2
^ j
1
t + A
1
^ j
2
t +jo
1
o
2
t
4A
1
A
2
, (52)
j
&o
=
A
1
A
2
+ A
2
^ j
1
t A
1
^ j
2
t jo
1
o
2
t
4A
1
A
2
, (53)
29
Clewlow and Strickland [7] show a multidimensional lattice with two assets which
follow correlated GBMs.
C VALUATIONOF ANANNUITYINPRESENCE OF MEANREVERSION34
j
o&
=
A
1
A
2
A
2
^ j
1
t + A
1
^ j
2
t jo
1
o
2
t
4A
1
A
2
, (54)
j
oo
=
A
1
A
2
A
2
^ j
1
t A
1
^ j
2
t +jo
1
o
2
t
4A
1
A
2
. (55)
The branches of the lattice have been forced to recombine by taking constant
increments A
1
and A
2
once the step size t has been chosen. Thus it
is easier to implement the model in a computer program. However, the
probabilities change from one node to another by depending on ^ j
1
and ^ j
2
.
Besides, it is necessary that at any time the four probabilities take on values
between zero and one.
C Valuation of an annuity in presence of mean
reversion
Our aim is to value an asset \ wich pays Adt continuously over a
nite number of periods t of remaining asset life, with A following a
mean-reverting process of the type:
dA = /(A
n
A)dt +oAd7
t
.
It can be shown that the asset \ satises the dierential equation:
1
2
\
AA
o
2
A
2
+ (/(A
n
A) jocA)\
A
r\ \
t
= A, (56)
where it is assumed that the existing traded assets dynamically span the
price A. Let j denote the correlation with the market portfolio, and c the
market price of risk:
c =
(r
A
r)
o
A
,
where r
A
stands for the expected return on the market portfolio and o
A
its
standard deviation. The solution \ (A, t) to the dierential equation must
satisfy the following boundary conditions:
a) At t = 0 the value must be zero: \ (A, 0) = 0.
b) Bounded derivative as A : \
A
(, t) < .
c) Bounded derivative as A 0: \
A
(0, t) < .
Using Laplace transforms we get:
1
2
/
AA
o
2
A
2
+ (/(A
n
A) jocA)/
A
/(r +:) =
A
:
.
Rearranging:
1
2
/
AA
o
2
A
2
(/ +joc)A/
A
/(r +:) = /A
n
/
A

A
:
.
C VALUATIONOF ANANNUITYINPRESENCE OF MEANREVERSION35
The general solution has the form:
/(A) =
1
A
o
1
+
2
A
o
2
+
A
IA
m
I+jo
:(: +r +/ +joc)
+
/A
n
(/ +joc):(: +r)
.
The derivative is bounded; thus
1
= 0. Besides, /(0) = 0; therefore
2
= 0.
The solution simplies to:
/(A) =
A
IA
m
I+jo
:(: +r +/ +joc)
+
/A
n
(/ +joc):(: +r)
.
With the rst and second derivatives: /
A
=
1
c(c+v+I+jo)
, /
AA
= 0, it is
possible to show, by substitution, that the dierential equation applies.
At this moment, the inverse Laplace transforms are taken. To do so we
use formula 29.3.12 in Abramowitz and Stegun [1], the nal result being:
\ =
/A
n
(1 c
vt)
r(/ +joc)
+
A
IA
m
I+jo
r +/ +joc
(1 c
(v+I+jo)t
). (57)
This formula may be useful to compute the present value of fuel costs over
the whole life of a plant with inexible technology, like an NGCC or coal
plant.
30
A series of particular, frequently used, cases may be derived from the
above general solution:
a) If c = 0 or j = 0, then the formula reduces to
\ =
A
n
(1 c
vt
)
r
+
A A
n
r +/
(1 c
(v+I)t
).
b) If t :
\ =
/A
n
r(/ +joc)
+
A
IA
m
I+jo
r +/ +joc
. (58)
In this case, it can be observed that the project value is the sum of two
components: one related to the reversion value and another one which
is a function of the initial dierence between the observed value and the
"normal" level of A.
c) When it is a perpetuity and also A
n
= 0 and / +joc = c, then:
\ =
A
r c
. (59)
d) When it is a perpetuity and also A
n
= 0 and / +joc = r +c, then:
\ =
A
c
. (60)
30
See Bhattacharya [4](eq. 15) and Sarkar [27] (eq. 2-4).
D THE PERPETUAL OPTION UNDER CERTAINTY 36
D The perpetual option under certainty
In this case o = 0 and hence the fuel cost follows a deterministic path:
o
t
= o
n
+ [o
0
o
n
]c
It
(which corresponds exactly to the mathematical
expectation of the stochastic case). If an investment is made at time T, it
will be worth: 454, 055, 483 83, 217, 315o
T
, which is the same value as in
the stochastic case when j = 0. The only dierence is that this is a future
value and that o
T
= o
n
+ [o
0
o
n
]c
IT
= 3.25 + 2.2c
0.25T
. Therefore
the present value at initial time of an investment to be made at time T is
derived by discounting at the riskless interest rate:
[454, 055, 483 83, 217, 315[3.25 + 2.2c
0.25T
]]c
0.05T
.
Dierentiating with respect to T and setting the derivative equal to zero,
the optimal investment time is T
= 7.1557 years. In that moment the

benets from waiting for a sure drop in gas prices fail to balance the eect
of discounting. Thus investment would take place when o
= o
T
= 3.6177.
This is the value o
will approach to as o 0.
Sensitivity analysis
Next we analyze the sensitivity of the results with respect to changes in
o, / and o
n
.
1. We assume several values for o while the others remain the same
(/ = 0.25, o
n
= 3.25).
Table A1. Trigger price o
as a function of o
o 0.00 0.02 0.05 0.10 0.15 0.20 0.25 0.30 0.35 0.40
o
3.62 3.59 3.49 3.25 2.99 2.74 2.52 2.30 2.11 1.94
As can be inferred from Table A1, the value of the option to wait
increases with volatility, which is reected in a lower threshold o
.
2. We consider several values for / while o = 0.20 and o
n
= 3.25.
First the special case in which / = 0 is computed;
31
then the dierential
equation (7) has the form:
1
2
1
00
o
2
o
2
r1 = 0, whose solution is: 1(o) =
1
o
1
+
2
o
2
, where
1
0 and
2
< 0 are the roots of a quadratic
equation. Since 1() = 0, it must be
1
= 0. In our case,
2
= 1.1583.
The boundary conditions are:
Value-Matching:
2
(o
2
= 1, 342, 055, 454 356, 448, 075o
,
Smooth-Pasting:
2
2
(o
2
1
= 356, 448, 075.
They suce to determine the value of o
for / = 0, which is 2.0206.

Computing the remaining parameters by the usual procedure, the results
are shown in Table A2.
31
The same results can be obtained by using equation (36) noting that if I = 0 then
c = 0, , = 0, = 2.5, 0 = 1.1583,
1
= 0 and A(o, /, 0) = 1. In this case
m
(,)
=
2
.
This shows that the solution using Kummers hypergeometric function includes other
simpler kinds of options as particular solutions.
as a function of /
/ \ (o) 1(o) o
/ = 0.00 1, 342, 055, 454 356, 448, 075o 2.0206

/ = 0.05 928, 778, 968 229, 286, 079o 2.2594
/ = 0.10 712, 083, 008 162, 610, 399o 2.4276
/ = 0.20 507, 699, 469 99, 723, 156o 2.6608
/ = 0.25 454, 055, 483 83, 217, 315o 2.7448
/ = 0.30 415, 510, 405 71, 357, 291o 2.8143
/ = 0.40 364, 000, 824 55, 508, 189o 2.9225
According to equation (27), natural gas costs depend on /. Therefore,
\ (o) 1(o) also depends on /. An increase in / pushes the trigger price
o
upwards, since prices will drop faster. In the limit, with an innite
reversion speed, prices reach the equilibrium value instantaneously thus
osetting the opportunity to wait until they fall. When / tends to zero,
the result converges towards the values of the above case in which / = 0.
3. Finally, let us consider several values of o
n
while o = 0.20 and
/ = 0.25. First the special case in which o
n
= 0 is computed; although it is
not very realistic, it allows to analyze the convergence towards another type
of option. In this case, the dierential equation has the form:
1
2
1
00
o
2
o
2
/o r1 = 0, whose solution is: 1(o) =

1
o
1
+
2
o
2
. Given that
1() = 0, it must be
1
= 0. In our case
2
= 0.182712.
In this case the conditions:
Value-Matching:
2
(o
2
= 1.342.055.454 83.217.315o
,
Smooth-Pasting:
2
2
(o
2
1
= 83.217.315,
allow to determine the value of o
for o
n
= 0, which is 2.4914.
After obtaining the remaining parameters by the usual procedure, Table
A3 shows the results.
as a function of o
n
o
n
\ (o) 1(o) o
o
n
= 0.00 1, 342, 055, 454 83, 217, 315o 2.4914
o
n
= 0.05 1, 328, 393, 916 83, 217, 315o 2.5016
o
n
= 0.50 1, 205, 440, 074 83, 217, 315o 2.5884
o
n
= 1.00 1, 068, 824, 964 83, 217, 315o 2.6737
o
n
= 2.00 795, 593, 934 83, 217, 315o 2.7925
o
n
= 3.00 522, 363, 173 83, 217, 315o 2.7848
o
n
= 3.25 454, 055, 483 83, 217, 315o 2.7448
o
n
= 3.50 385, 747, 793 83, 217, 315o 2.6769
o
n
= 3.75 317, 440, 103 83, 217, 315o 2.5645
o
n
= 4.00 249, 132, 413 83, 217, 315o 2.3687
It can be observed that changes in the trigger price o
are relatively
small in the range between o
n
= 1.00 and o
n
= 3.50.
Given o = 5.45, for very low values of o
n
the option value increases more
than the immediate investment value, with the equilibrium being reached
for lower values of o
. For high values of o

n
the option value is low, while
the net investment value takes on negative values which are oset if the
trigger price o
falls more.
REFERENCES 39
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REFERENCES 40
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Igcc and NGCC

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Technology choice for power plants

under mean reversion in fuel prices

= 83, 217, 315 = \

. Substituting the value

which has as its solution o

will take on a value between 5.4563 and 2.7448.

with nite time to maturity

= 7.1557 years. In that moment the

for / = 0, which is 2.0206.

/ = 0.00 1, 342, 055, 454 356, 448, 075o 2.0206

/o r1 = 0, whose solution is: 1(o) =

. For high values of o

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