The feasibility of wind energy projects – as well as in most other economic areas – has been assessed for years now by means of cash-flow-models, which deliver illustrative key figures such as the Internal Rate of Return (IRR) or the Net Present Value (NPV), to name two of the most important ones. The logic is: Only if a project delivers a NPV greater zero and passes an expected IRR-threshold, one should invest.
Most investment decisions include some elements of uncertainty. Managers know that they must proactively manage investments by changing subsequent plans amid changing market conditions. They also intuitively know that standard financial tools often fail in these situations and they have to change gear mentally. For example:
- For strategic investments, standard tools do not lead managers to ask the right questions: Is it advisable to enter into a new market (e.g. regional expansion) or should only established markets be considered?
- For transaction valuations, such as the pricing of acquisitions and the sale or licensing of assets, standard tools rely on subjective inputs, so the results are not consistent with valuations in the financial markets.
- For strategic vision, standard tools do not provide the integrated framework to link project analysis and the market value of the firm. Do we know why and when our strategy is value-increasing?
The assumption of a predictable development of the economic, technical and political framework within the next 20 years or so may be highly unrealistic. Beyond, the real possibilities of management to respond to changes to this framework may not be taken into account: The regulatory environment may change dramatically, new technology will undoubtely be on the agenda and the prospects of the electricity markets can – for the time being - only be seen as a shadow.
Therefore, the NPV- and IRR-Approach may lead to second-best results, especially when variations with positive or negative impacts are quite likely but not considered in today’s prevailing financial assessment tools. The question is: Are there better ways of evaluating risks and chances? Are there other approaches lurking behind the bushes? We will argue that the real options approach may in some areas offer some substantial advantages.
|Dr. Jörg Böttcher|
The timing of market entry
One tricky question for investors is always the timing of market entry, since the regulatory environment may change and thus influence project’s overall profitability. The following example is motivated by our experience that the predictability of the regulatory regime is crucial for any project.
Let us suppose that a decision about the regulatory regime (feed-in tariff versus quota-based system) will occur in 2017 with a major impact on wind industries prospects in Europe. Any investor will ask himself: What is the optimal timing for market entry - should I invest now or should I wait? The following example represents the key figures of a typical wind farm in Germany and the characteristics of the Renewable-Energy Law.
Suppose you can invest today 16.000 currency units (“CU”) equity, which will produce an infinite annuity with an expected value of 1.680 CU and the interest rate being 7 %.
Continue reading » here.