Valuation of Generation Assets - a Real Option Approach by Frode Kjærland Doctoral thesis submitted to the Bodø Graduate School of Business For the deg ree of Ph.D. Høgskolen i Bodø 8049 Bodø Tlf: +47 75 51 72 00 Fax: +47 75 51 72 68 www.hhb.no ACKNOWLEDGEMENTS I would like to thank several people for helping me to write Ihis thesis: Y Professor Terje Vassdal (NCFS/UiT) as supervisor and Professor Frøystein Gjesdal (Nonvcgian School of Econom!cs and Business Administration) and Professor Goran Bergendahl (School of Business, Economics and Law, University of Gothenburg) as co-supervisors for their out­ standing academic feedback regarding the material handled in the thesis. y Six anonymous referees in different journab for providing excellent feed­ back conceming h",o of the chapters. ,. The energy companies in the region, amongst them SKS and Bodø Energi, which have provided the financial foundation for my work as a PhD stu­ dent ,. Kjell Kriiger, NORSEC, and Stein Mørtsell, SKS, for willingly ans\vering my questiont> about the power generation industry, especially with respect to the first half of the project. ,. The administration at Bodø Graduate School of Business that has most willingly supported me in finding solutions at every stage of the project. y Several faculty staff at Bodø Graduate School of Business for being most helpful concerning various academic challenges during my \\/Ork. Associ­ ate professor Rolf Volden has been outstanding with regard to the econo­ metric assessments in Chapters 4 and 6, Associate professor Berner Larsen has at>t>isted with the MATLAB programming in Chapter 5, as well as sev­ eral issues in the model application used in chapter 6, inc\uding the R source code programming. Fellow PhD student Telje Andreas Mathisen deserves acknowledgment for patiently assisting in the use of STA T A for some ofthe econometric tests perfonned in Chapter 4 and 6. y All colleges at the Bodø Graduate School of Business, and especially those working in the "J-Iengmyra" corridor, for making this a good place for the work. Y Europower AS, the Nordic power exchange Nord Pool and Brønnøysund Register Centre for providing necessary data. -111- 'j.- Peter Glanfield and my brother Trond, for assisting in my severe difficul­ tie~ in writing this thesis in English. Bodø, Nonvay, January 2009 -IV- TABLE OF CONTENTS CHAPTER 1: INTRODUCTION ......................................................... 1 1.1 Background and Motivation .................................................................. 1 1.1.1 The Advantages of a Real Option Approach in Valuation ....................... 2 1.1.2 Real Options and Accounting Disclosure ................................................ 4 1.2 The Research Problem of the Thesis .......................................................... 5 1.3 The Generation Industry of Norway ............................................................7 1.4 Thesis Structure and Outline ..................................................................... 12 1.4.1 Chapter 2: Theoretical Foundation and Methodology ........................... 13 1.4.2 Chapter 3 (paper 1): The Use, Abuse and Lack of Use of Real Options13 1.4.3 Chapter 4 (paper 2): Explaining the Value of Electric Utilities by Real Options - An Application to Norway ............................................................... 15 1.4.4 Chapter 5 (paper 3): A Real Option Analysis of Investments in Hydropower - The Case of Norway ............................................................... 15 1.4.5 Chapter 6 (paper 4): The Value of Operational Flexibility by Adding Thermal to Hydropower - a Real Option Approach ....................................... 16 1.5 Summary and Key Contributions .............................................................. 17 References .........................................................................................................19 CHAPTER 2: THEORETICAL FOUNDATION AND METHODOLOGY ............................................................................ 23 2.1 Valuation ......................................................................................................23 2.2 Real Options ................................................................................................24 2.3 Valuation of Real Options ..........................................................................27 2.4 Methodology ................................................................................................29 2.5 Real Options and Philosophy of Science ................................................. 29 2.6 Research Design .........................................................................................32 2.6.1 Data ........................................................................................................35 2.6.2 Unit of Analysis ......................................................................................36 -v- References .........................................................................................................36 CHAPTER 3 (PAPER 1): THE USE, ABUSE AND LACK OF USE OF REAL OPTIONS ........................................................................ 41 3.1 Introduction ................................................................................................. 42 3.2 Key Findings from Relevant Surveys on the Use of Capita I Budgeting Techniques ........................................................................................................ 44 3.3 Four Aspects regarding Why there is Limited Use of the Real Option Tool .....................................................................................................................47 3.4 The Use of Real Options: An Application to the Norwegian Generating Industry ..............................................................................................................51 3.4.1 Valuation reparts of Statkraft SF ............................................................ 52 3.4.2 Contact with financial managers in generating companies ................... 53 3.5 Conclusions and Implications ................................................................... 55 3.5.1 The answer to research question 1: ...................................................... 56 3.5.2 The answer to research question 2: ...................................................... 56 References .........................................................................................................58 CHAPTER 4 (PAPER 2): EXPLAINING THE VALUE OF ELECTRIC UTILITlES BY REAL OPTIONS - AN APPLlCATION TO NORWAY63 4.1 Introduction ................................................................................................. 64 4.1.1 Real options, valuation and Norwegian electric utilities ........................ 67 4.1.2 The electricity market in Norway ........................................................... 68 4.2 The Residuallncome Model and Research Design ................................. 70 4.2.1 Research design .. _ .... _.... 73 4.2.2 "Real option" variables.. .... _.... 79 4.3 Data, empirical results and analysis ......................................................... 83 4.3.1 Empirical results and analysis ............................................................... 89 4.4 Conclusions, Implications and Limitations .............................................. 97 References .........................................................................................................99 Appendix 1 ....................................................................................................... 105 Appendix 2 ....................................................................................................... 107 -VI- Appendix 3a .....................................................................................................109 Appendix 3b .....................................................................................................110 CHAPTER 5 (PAPER 3): A REAL OPTION ANALYSIS OF INVESTMENTS IN HYDROPOWER - THE CASE OF NORWAY 111 5.1 INTRODUCTION ..................................................................... 112 5.2 Methodology ..............................................................................................115 5.3 The Application of the Dixit & Pindyck Modelon Norwegian Hydropower Investment Opportunities ........................................................ 119 5.3.1 Data for applying the model.. .. ............ 119 5.3.2 Analysis of option value and trigger price.. .. ............ 127 5.4 Conclusions and Implications ................................................................. 132 References .......................................................................................................135 Appendix 1: MATLAB programming ............................................................. 138 CHAPTER 6 (PAPER 4): THE VALUE OF OPERATIONAL FLEXIBILlTY BY ADDING THERMAL TO HYDROPOWER - A REAL OPTION APPROACH ......................................................... 142 6.1 Introduction ...............................................................................................143 6.1.1 Background and motivation . .. ............. 144 6.2 Operational Flexibility, the Alternative Cost of Hydro Generation and the Operational Cost of Thermal Generation ............................................... 148 6.2.1 Reservoir level, short term forward prices and the alternative cost of hydro generation ..........................................................................................