Researchers at Argentina's National Scientific and Technical Research Council (CONICET) have developed a comprehensive pricing framework for photovoltaic assets that reportedly shows how different real options embedded in a PV project interact with each other and how they affect the optimal timing and value of investment strategies.
“Our new methodology allows accommodating different sources of uncertainties with different stochastic features as well as accounting for the various managerial flexibilities embedded in most solar projects,” the research's corresponding author, Bruno Mombello, told pv magazine. “As uncertainty resolves and decisions proceed, often new options open to managers such as expanding capacity, relocating facilities, or disinvesting. Successive decisions can be assimilated into a portfolio of sequential, mutually coupled options. Our work advances on the current practice of valuing standalone options, as flexibilities are jointly priced as a compound multi-stage option portfolio which is optimally exercised.”
In the paper “Valuing photovoltaic power plants by compound real options,” published in Renewable Energy, Mombello and his colleagues explained that investments in photovoltaic assets should be made by pricing the projects as interacting multi-stage compound options, and not as standalone options.
“Renewable energy projects are being subjected to increasing uncertainties,” Mombello said. “Power price fluctuations, policy changes, subsidies withdrawals, emerging transmission congestions, and development of PV costs may have a deep impact on the economic profitability of renewable investments. The high energy and solar price volatilities experienced in recent years due to pandemics, war, and geopolitical conflicts are fresh and tangible examples of the substantial risks that renewable projects are facing.”
A compound option is usually defined as an option to receive another option as the underlying security. Simply speaking, it is an option on an option. The scientists said that the combinations of classical options, such as deferring, expanding, and relocating the plant, are jointly priced as sequential compound and mutually exclusive options. “Both relocation and mutually exclusive options have been previously overlooked when pricing PV projects,” they specified.
The proposed methodology is based on the least-squares Monte Carlo (LSM) simulation approach, which is used to assess unpredictable outcomes influenced by random variables, by reducing complex processes to a set of basic events and interactions.
The LSM algorithm used by the research team combines dynamic programming, stochastic simulation, and linear regression to estimate the continuation value, which is the present value of all cash flows that will occur before the terminal year of an asset's expected lifetime. “The continuation function cannot be estimated by excluding out-of-the-money paths in compound options pricing,” the group specified.
The academics evaluated different option portfolios and found that the value of a PV project increases with the number of options included in the PV investment portfolio. “Option portfolios with the same options but different exercising order have different values,” they stated. “An option written on another one that modifies the underlying asset affects both backward and forward options. This changes their optimal exercise time.”
The researchers explained that, currently, PV project developers and investors price only the deferral option, which they said may lead to a significant undervaluation of solar investments. “The consideration of compound options and their implications can enhance the understanding of the actual worth of flexibility to manage uncertainty,” they concluded.
In 2019, the same research group developed a methodology for assessing the value of PV in uncertain markets. The researchers say their tool may bring to fruition projects exposed to risks related to competition, fuel and electricity price volatility, technological advances, environmental issues, and unstable regulatory regimes, among other problems.
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