Renewable and Sustainable Energy Reviews 75 (2017) 918–926

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Renewable and Sustainable Energy Reviews

journal homepage: www.elsevier.com/locate/rser

Real options analysis for renewable energy investment decisions in MARK

developing countries
⁎
Kyeongseok Kim, Hyoungbae Park, Hyoungkwan Kim
School of Civil & Environmental Engineering, Yonsei University, Seoul 03277, South Korea

A R T I C L E I N F O A BS T RAC T

Keywords: Renewable energy projects in developing countries should provide clean energy supply as well as support
Renewable energy sustainable economic development. To this end, risks arising from uncertainties such as rapidly changing
Real options analysis technologies and host government conditions should be carefully addressed. However, traditional methods for
Developing country economic assessment are not adequate to support decision-making regarding investments in renewable energy.
Volatility
This paper proposes a real options analysis framework as a tool to assess renewable energy investment in
Hydropower
developing countries. A case study involving a hydropower project in Indonesia was conducted to validate and
verify the proposed framework. This framework is expected to help host countries and investors assess
renewable energy projects with high volatility and risk.

1. Introduction difficulty of decision-making in RE investment. This paper proposes a

Due to global climate change, developed countries have continued
to reduce their use of fossil fuels and increase their use of renewable
energy (RE). By 2012, as a result of the Kyoto Protocol, RE production
reached an estimated 22.1% of global electricity production [1]. Total
new investment in renewable power was at least US$249.4 billion in
2013 [1]. Since 1990, RE generation worldwide has grown by an
average of 3.3% per annum: 2.3% among countries in the Organization
for Economic Co-operation and Development and 4.5% among other
countries [2].
The RE industry has expanded more quickly in developing coun-
tries facing rapid economic growth and severe energy shortages. The
continual decline in prices of RE material and equipment caused by
technological advancements have improved the applicability of RE in
recent decades. Governments of developing countries have played a
role in the growth of the RE market by attracting foreign investors for
RE business opportunities, by means of new energy policies such as
feed-in tariffs, renewable portfolio standards, deregulation, incentive
programs, and public–private partnership models. The RE business
has created an energy industry boom and has filled a gap in the
electricity supply in emerging economies including developing coun-
tries in Asia, Africa, and South America.
Despite the positive aspects of RE markets, it is difficult to make
decisions regarding RE investments in developing countries. Risks
arising from changeable policies, loan rate fluctuations, foreign ex-
change rates, and inflation are typical examples that illustrate the
real options analysis (ROA) framework for the assessment of invest-
ments in RE projects of developing countries. RE projects in this study
are defined to include electricity-generating power plants powered by
hydropower, solar, geothermal, bioenergy, wind, or marine (tide and
wave) energy sources. The two objectives this paper attempts to achieve
are the accurate estimation of uncertainties arising from investment in
RE projects of developing countries and the accurate assessment of
economic feasibility of such investments. This paper first identifies the
key variables to assess the uncertainties that have a direct influence on
the project profit. ROA is then conducted to yield the option value to
decide whether or not the project is economically feasible. The
proposed framework enables investors to accurately evaluate RE
projects with regard to the major risks associated with these projects.
The entire process of planning, designing, constructing, and operating
RE projects in developing countries is covered in this framework.
2. Literature review
Developers, financial institutions, and government agencies com-
monly assess investments using the net present value (NPV) technique
under the condition of definite cash flow. The NPV technique is the
most widely used decision-making tool for various investment projects.
This traditional approach is known to be quite useful in many projects,
but not in the case of highly volatile and uncertain investments.
Because RE projects in emerging markets entail considerable risk
influenced by rapidly changing RE technologies and global climate

⁎
Corresponding author.
E-mail addresses: kim.ks@yonsei.ac.kr (K. Kim), hyungbae48@korea.kr (H. Park), hyoungkwan@yonsei.ac.kr (H. Kim).

http://dx.doi.org/10.1016/j.rser.2016.11.073
Received 14 October 2015; Received in revised form 9 October 2016; Accepted 1 November 2016
Available online 12 November 2016
1364-0321/ © 2016 Elsevier Ltd. All rights reserved.
K. Kim et al. Renewable and Sustainable Energy Reviews 75 (2017) 918–926

change, the traditional method for economic assessment does not Table 1
adequately meet the requirements of RE projects in developing Summary of real options literature.
countries. NPV has long been authorized as an investment decision
Authors Country RE type Year Uncertainty Ref.
technique for energy projects; however, it is considered inappropriate
for highly uncertain investment projects because it intrinsically carries Batista et al. Brazil Hydropower 2011 CER price [26]
the assumption of definite cash flows. The limitations and weak points Zavodov China Hydropower 2012 CER price [29]
Zhang et al. China PV 2016 Non-renewable [40]
of NPV have become more obvious when NPV is compared with ROA.
energy cost, Tariff,
Amram and Kulatilaka [3] and Copeland and Antikarov [4] applied CER Price,
ROA to highly volatile investment projects in the areas of oil, gas, Investment cost
mining, research and development, aviation, telecommunication, phar- Yang et al. China Wind 2010 CER price [28]
maceuticals, and semiconductors. Weibel and Germany Hybrid 2015 Energy [46]
Madlener production, Tariff,
Recently, ROA has been more frequently applied for valuation of
Investment costs
RE projects. ROA has been used for various types of RE, including Reuter et al. Germany Wind 2012 Tariff [18]
hydropower [5–7], wind farms [8–12], and solar energy [13,14]. Kroniger and Germany Wind 2014 Energy [47]
Studies have been conducted to improve ROA methodology for RE Madlener production, Tariff,
Capacity
[15–18]. Policy issues for RE have also been addressed [19–25]. The
Venetsanos Greece Wind 2002 Tariff [12]
Clean Development Mechanism (CDM) for RE projects is another et al.
important issue that has been studied [26–29]. Additionally, invest- Lee et al. Indonesia Hydropower 2013 CER price [27]
ment in RE projects in developing countries has also been explored Kim et al. Korea Hydropower 2016 Energy [39]
[30–33]. Particularly, Kurbatova and Khlyap [34] and Kaygusuz [35] production, Tariff,
O & M cost
argued that political and economic factors encourage developing
Jeon et al. Korea PV 2015 Tariff, Energy [42]
countries to develop RE projects and new energy policies, and that production,
RE strategies be changed with consideration to the increasing levels of Interest rate, Risk
future energy consumption. Huenteler [36] suggested the role of donor free rate,
Exchange rate
countries in helping developing countries ease the high uncertainty of
Kim et al. Korea PV 2016 Energy [48]
feed-in tariff. production, Tariff
The volatility of project cash flow is much more important in RE Kim et al. Korea Wind 2014 Non-renewable [49]
projects than in traditional energy projects. Systematic and compre- energy cost
hensive analysis is increasingly useful for investigating the volatility Detert and Mongolia Wind, PV 2013 Non-renewable [41]
Kotani energy cost
arising from uncertainties of RE projects. Bøckman et al. [5] developed
Boomsma Nordic region Wind 2012 Tariff [16]
a real options model for a small hydropower project in Norway, to find et al.
the unique trigger price for investing and the optimal size of the Kjærland Norway Hydropower 2007 Tariff, Investment [6]
hydropower plant. Kjærland [6] applied the real options model frame- cost
Bøckman et al. Norway Hydropower 2008 Tariff [5]
work for potential hydropower investments to quantify the option value
Lee and Shih Taiwan Wind 2010 Tariff, Costs [23]
based on different timing and investment behaviors in Norway. Abadie Lee Taiwan Wind 2011 Underlying price, [37]
and Chamorro [8] developed a real options model to investigate a wind Exercise price,
farm project considering the three uncertain factors of electricity price, Operation Time,
wind generation quantity, and subsidy in the UK. Lee [37] demon- Risk-free rate
Kumbaroğlu Turkey Wind 2008 Tariff [38]
strated the effectiveness of ROA for a wind energy project in Taiwan
et al.
and argued that the value of RE investment increases when underlying Martinez‐ UK PV 2013 Tariff [14]
price, time to maturity, risk-free rate, and volatility increase. Martinez- Cesena
Cesena and Mutale [11] proposed a real options methodology to assess et al.
the value of small wind power projects. Venetsanos et al. [12] Abadie and UK Wind 2014 Tariff, Energy [8]
Chamorro production,
developed an evaluation method for uncertainties associated with wind Subsidy
energy projects after deregulation of the electricity market in Greece.
Kumbaroğlu et al. [38] presented a policy planning model integrating
learning curve information on RE technologies into a dynamic pro- Previous studies were primarily carried out for developed countries
gramming formulation featuring ROA in a Turkish case. such as the UK, Greece, Germany, Korea, and Norway. However, there
Many researchers evaluated RE projects by taking into account are few studies that analyze RE investments in developing countries
volatility within economic, environmental, and technical factors. Kim such as China, Brazil, Indonesia, and Mongolia.
et al. [39] identified three key variables (energy production, tariff, and A RE project includes uncertainties influenced by costs during the
O & M costs) to understand uncertainty in hydropower projects in development phase and cash flow during the production phase. Typical
Korea, and forecasted the future energy production derived from the development costs include site survey, feasibility study, design, and
projected future precipitation. Zhang et al. [40] suggested a ROA model construction. These costs are subject to private risk, as opposed to
for evaluating solar photovoltaic (PV) power projects in China, by market (public) risk. Cash flow during the production phase is typically
considering variable factors including CER price, non-renewable calculated as the net of expected revenue minus production costs [43].
energy cost, investment cost, and tariff. Detert and Kotani [41] Cash flow is usually influenced by market risk only [43]. The marketed
compared coal-based power and renewable energy by considering the asset disclaimer (MAD) approach is applicable to both market and
sole uncertain cost of coal in Mongolia. Jeon et al. [42] proposed a real private risks [44]. This approach presents the practical challenge of
option model to estimate optimal subsidy in PV investment, reflecting developing a cash flow model and associated subjective input variables.
uncertainties such as tariff, energy production, interest rate, risk However, because the MAD approach is applicable to any investment
premium, risk free rate, and the exchange rate in Korea. [45], it was adopted in the ROA framework for RE projects developed
Table 1 summarizes the relevant literature that used the real in this study.
options approach, and classifies it according to countries, RE type, The issues addressed in previous studies on the application of ROA
and uncertainties. It illustrates the lack of literature that profoundly for RE projects can be categorized into applicability of ROA to a
analyzes the uncertainties of RE projects in developing countries.

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K. Kim et al. Renewable and Sustainable Energy Reviews 75 (2017) 918–926

particular natural resource, improvement of assessment methodology,

RE policy issues, and CDM. Previous studies have advanced the state of
the art in the application of ROA to RE projects. However, methodol-
ogies applicable to a range of RE projects, especially in developing
countries, are lacking. Accordingly, this paper seeks to provide a ROA
framework applicable to various energy sources of RE and also
considers the whole process of project investment in developing
countries.

3. Methodology

3.1. Framework for investment decisions on RE projects in

developing countries

Copeland and Antikarov [4] showed a four-step process to carry out

the MAD approach for projects in general, Herath and Park [50]
proposed a multistage decision framework for research and develop-
ment projects, and Kodukula and Papudesu [43] introduced a six-step
ROA process based on the MAD approach. The above-mentioned
methodologies are applicable to many different types of investments;
however, they are not tailored to meet specific requirements of a
particular type of project. It is difficult for investors to properly valuate
RE projects by using general ROA approaches, especially projects in
developing countries. To resolve these difficulties, a framework is
proposed herein for investment decisions regarding RE projects in
developing countries. The proposed framework is composed of four
major steps: investment scenario development, cash flow development,
real options valuation, and decision-making (Fig. 1). Step 1 is the
development of an investment scenario for a RE project considering the
specific natural energy source. In this step, the project timeline is
developed and distinguishes between the different phases of planning,
design, and construction and operation. These phases are determined
by the timing of cash inflow from investors. Step 2 is the development
of cash flow for predicting future cash flow. The key variables of energy
production, tariff, price of certified emission reductions (CERs), and
operation and maintenance (O & M) costs are identified in this step.
Step 3 is the real options valuation of the RE project. For estimation of
the volatility of a project's value, a three-point estimation technique
(optimistic, pessimistic, and most-likely) is adopted [4,43,44,51]. A
compound option model with a binomial lattice structure is also
Fig. 1. ROA framework for investment decision of RE projects in developing countries.
adopted to represent the sequential nature of RE projects. Step 4 is
the final decision regarding whether or not to invest in the project. The
decision is made by comparing the real options value with the NPV.
Sensitivity analyses are also conducted to quantify the impact of each
key variable on the value of the project.

3.2. Compound option model

Many investment projects have multiple decision stages, meaning

that management can decide to expand, reduce, delay, or abort the
project after gaining new information to resolve uncertainties [43]. A
capital investment may include the planning, design, construction and
operation phases, each of which requires a go/no-go decision.
Regarding the life cycle of RE projects specifically, a general business
process would include three phases: planning, design, and construction
and operation. During the planning phase, investors conduct a financial
and technical feasibility study considering the limits inherent in the
time frame and available resources. If management approves continu-
ing into the design phase, investors could decide to invest in that phase.
During the design phase, investors can obtain design documents,
allowing them to understand the scope and cost of the next phase:
construction and operation. Finally, during the construction and
operation phase, investors receive their payoff from the operation of
the energy plant over a long period of time. RE projects in developing
countries include quite a few uncertainties throughout the life cycle of
the project. The compound option model used herein is based on a
Fig. 2. Compound option model for RE projects in developing countries.
three-phase project cycle comprised of the planning, design, and
construction and operation phases (Fig. 2). The three phases of the
option model correspond to the investment opportunities available
during a project. At the beginning of the planning phase, investors have
the option to fund the design phase or to opt out and abandon the
project. The same situation occurs most notably at the beginning of the
design phase and at the beginning of the construction and operation
phase. The compound option model can be applied to the analysis of
RE projects including those powered by hydropower, solar, geothermal,
wind, and ocean sources.

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3.3. Option valuation Table 3

Three cash flow scenarios of a project.
Risks from uncertainties affect the volatility of cash flow. A high
Period (n) Best case Moderate case Worst case
level of uncertainties indicates a high level of risk and corresponds with
extremely volatile cash flow. The characteristics of the volatility should 1 Cash flowbest_1 Cash flowmoderate_1 Cash flowworst_1
be carefully investigated and understood so as to minimize the relevant 2 Cash flowbest_2 Cash flowmoderate_2 Cash flowworst_2
risk. RE projects in developing countries entail numerous uncertain 3 Cash flowbest_3 Cash flowmoderate_3 Cash flowworst_3
: : : :
factors such as inflation, interest rate, tax, exchange rate, planning cost,
n Cash flowbest_n Cash flowmoderate_n Cash flowworst_n
design cost, site acquisition cost, construction cost, insurance cost,
operation and maintenance cost, change in laws, natural disasters,
political force majeure, CER price, energy production, tariff, and Sopt
ln( S )
concession periods. However, it is vitally important to choose key σ=
pes

variables that will have maximum influence on the project's profit-
ability and thus allow management to maximize the likelihood that the
project succeeds.
The proposed ROA framework incorporates tariff, O & M cost,
energy production, and CER price as key variables for the following
reasons. First, developing countries are known to have relatively
unstable economies characterized by high inflation and interest rates.
Thus, it is crucial to consider the variables of tariff and O & M cost,
which can reflect high inflation and interest rates. RE tariffs are
specified by the power purchasing agreements, which in turn are based
on the relevant governments’ RE policy schemes. A RE tariff specifies
compensation for initial investment costs, O & M cost coverage, sub-
sidies provided as investment incentives, and the base price of
electricity; these components of the tariff are affected by the inflation
and interest rate of the developing economy. O & M costs are also
influenced by inflation and interest rates, and thus are included as a
key variable. Secondly, RE production is an obvious major contributor
to the revenue of a RE project, so it is selected as a key variable. Unlike
conventional energy production, RE energy production depends on
aspects of renewable resources including rainfall, wind density, day-
light period, tidal current, and underground temperature. Because
renewable resources are difficult to predict and control, estimation of
RE production must be conducted carefully. Third, CERs under the
Kyoto Protocol are a key incentive for investing in RE projects in
developing countries. CER price tends to fluctuate randomly according
to market demand [44], so in order to better control the risk associated
with the CER price, it is also selected as a key variable.
As mentioned above, the MAD approach and three-point estimation
were used for real options valuation of a RE project in a developing
country. The MAD approach allows for the use of the traditional
concept of discounted cash flow: the underlying asset value can be
calculated from the present value of the most-likely cash flow scenario.
The most-likely (moderate) scenario is the situation between the
optimistic (best) scenario and pessimistic (worst) scenario. Table 2
shows input variables used to calculate cash flow for RE projects in
developing countries. Cash flows for each of the three scenarios are
obtained by combining the multiple uncertainties of input variables.
For example, combining the best situations for all input variables of O
& M cost, energy production, tariff, and CER price yields the optimistic
cash flows. Table 3 shows cash flows for each period in the three
scenarios.
Assuming that the project value follows a lognormal distribution,
the volatility can be estimated using the following equation [43]:
4 t (1)
where Sopt is the underlying asset value under the optimistic scenario,
Spes is the underlying asset value under the pessimistic scenario, and t is
the project period, respectively.
Option values are calculated by the binomial lattice model. Up
movement (u ), down movement (d ), risk-neutral probability (q ), and
option value (C ) are estimated using Eqs. (2)–(5), respectively.
u = eσ ∆t (2)
1
d=
u (3)
(ert −d)
q=
u−d (4)
C= e−rt [qC u +(1 − q)Cd] (5)
Here, r is the risk-free interest rate and C u and Cd are option values
respectively associated with up and down movements.
4. Case study: application of the proposed framework to an
Indonesian hydropower project
4.1. Case description
Indonesia had an electrification rate of 74.4% in 2012 due to
geographic complexity and other reasons [52]. The demand for
electricity in Indonesia increases significantly each year. The national
government set a goal of increasing the RE share of the energy supply
from 5.7% in 2013 to 17% by 2025 in its National Energy Policy [52].
However, due to a lack of public funding, many RE projects are
implemented by means of the public–private partnership approach,
which entails joint efforts by government and private parties. The
Indonesian government and foreign investors need an effective analysis
tool that clearly shows the value of a RE project and considers the
uncertainties and risks of such projects in Indonesia.
The case study project is a run-of-the-river hydropower plant with
the electricity generation capacity of 46.8 MW, located in the North
Sumatra province. Table 4 lists the details of the case study project in
condition of the moderate (most-likely) case. The total project cost is
US$151.098 million and the project period is 35 years, as shown in
Table 4. As mentioned above, four variables most likely to affect the
volatility of this project were considered: tariff, O & M cost, energy
production, and CER price. Though the investment (construction) cost

Table 2
Input variables using the three-point estimation..

Variable Best case Moderate case Worst case

O & M Cost O & M Cost best O & M Cost moderate O & M Costworst
Energy production Energy productionbest Energy production moderate Energy production worst
Tariff Tariffbest Tariffmoderate Tariffworst
CER price CER pricebest CER pricemoderate CER priceworst
Combined Cash flowbest Cash flowmoderate Cash flowworst

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Table 4 moderate case.

Details of the case study project (based on the moderate case). In step 3, three-point estimation was carried out to provide a range
of values for each of the variables, in each of the best, moderate, and
Items Values
worst scenarios. In the case of tariff, the value for the moderate
Installed generator capacity 46.8 MW scenario was increased by 30% to estimate the best-case value, and was
Type of Business BOO (Build-Operate-Own) decreased by 30% to estimate the worst-case value. Similarly, the O &
Total project cost US$151.098 Million
M cost value in the moderate scenario was increased by 30% for the
Planning period 1 Year
Design period 1 Year worst scenario and decreased by 30% for the best scenario. Energy
Construction period 3 Years production was assumed to be 82.56% of the maximum capacity
Concession period 30 Years (100%) in the moderate scenario, and production in the worst scenario
risk-adjusted discount rate 9.69% was assumed to be 57.79%, a value decreased by 30% from that of the
risk-free rate interest rate 6.00%
moderate case. The efficiency of energy production was estimated
O & M costs 0.011833 US$/kW h
Electricity tariff 0.0811 US$/kW h taking into consideration operation time, runoff, and machinery.
CER price 17.65 US$/tCO2 The case study project had the advantage of eligibility for CERs
under the CDM, as defined in the Kyoto Protocol. The CDM methodol-
ogy titled “ACM0002 (version 12.1.0): Consolidated baseline metho-
is certainly an important variable, it was assumed to be a fixed factor in dology for grid-connected electricity generation from renewable
this study. The periods of planning, design, construction, and operation sources” was adopted to estimate baseline carbon emissions for the
are 1, 1, 3, and 30 years long, respectively. Investors have three case study project and to calculate its emission factor [53]. A combined
opportunities to make investment decisions (as previously explained in grid emission factor of 0.743 tCO2e/MWh was determined based on
Section 3.2): (1) now (or year zero), regarding whether to invest in the the most recent run-of-the-river hydroelectric projects in the Sumatra
planning phase, (2) at year 1, regarding whether to continue into the area; the relevant data was obtained from the CO2 baseline database
design phase, and (3) at year 2, regarding whether to construct the RE issued by the Agency for the Assessment and Application of Technology
project. The project value was calculated using these options based on and the Directorate General of Electricity and Energy Utilization under
the proposed ROA framework. the Ministry of Environment of Indonesia [54]. CER price was
investigated using historical data on the European Climate Exchange
(ECX) of the Intercontinental Exchange (ICE) between March 2008
4.2. Real options analysis according to the proposed framework and August 2015 (Fig. 4). For the three-point estimation, the best-case
CER price was assumed to be 25.38 US$/tCO2, which was the highest
Using the ROA framework illustrated in Fig. 1, the RE project was price during the historical period considered. The worst-case price was
valuated. In step 1, a scenario involving investment timing was assumed to be 0.02 US$/tCO2, the lowest price during the same
developed. The planning cost was assumed to be US$1 million and period. The moderate value was assumed to be 12.70 US$/tCO2, the
occurring now (year zero). The result of the planning phase affected the average of the two extremes.
decision to continue to the design phase and determined whether the Using the MAD approach, the cash flows in the moderate scenario
next step would be taken or the project abandoned. The investment were discounted back to a present value using the risk-adjusted interest
cost of the design phase was US$10 million, and its timing was one rate for calculation of the asset value at the present time. The current
year later. Likewise, the result of the design phase affected the decision value of the underlying asset in the moderate scenario was US$141.4
to invest US$149.098 million in the construction and operation phase. million. The yearly volatility of project return was estimated to be
The construction time was three years and the operation period was 30 14.32% using Eq. (1). The use of Eq. (1) required making assumptions
years. regarding the underlying asset values under the optimistic and
In step 2 of the ROA framework, the key variables were identified to pessimistic scenarios (Fig. 5). The up movement (u ), down movement
allow for computation of the projects’ cash flow. Table 5 shows the (d ), and risk-neutral probability (q ) were estimated to be 1.1540,
values of the four variables for each of the three scenarios: moderate, 0.8665, and 0.6794, respectively, by using Eqs. (2)–(4). Fig. 6 shows
best, and worst. These were later used to estimate the volatility of the the compound option model, illustrating the multistage nature of the
project value. However, the moderate case was used to generate the investment decision timing and the investment amounts corresponding
future cash flow used to estimate the current value of the underlying to each decision. The compound option values of the case study project
asset. Fig. 3 shows the cash flow in the moderate case. Revenue was the were calculated using the binomial lattice and Eq. (5). The option value
positive value obtained from the energy production and tariff. Energy (strategic net present value; SNPV) of the project was estimated to be
production was assumed to be constant throughout the project life- US$12.6 million.
span. The tariff increased with inflation over time. O & M cost was a Investors could make various investment decisions at each node of
negative value that increased over time due to inflation. CER revenue the binomial lattice (Fig. 7). The three investment decisions were US$1
was also estimated to remain constant throughout the project's million for the planning phase, US$10 million for the design phase, and
operation period. The conventional NPV was US$6.3 million in the US$140.1 million for the construction and operation phase. At the
current time (node 1), if the startup cost were larger than the option
Table 5 value (US$12.6 million), the project should be abandoned. However,
Variables of the case study project under the three-point estimation.
because the initial investment cost is only US$1 million, the project is
Variable Best Moderate Worst worth pursuing. If the market uncertainty does not disappear by the
end of the design phase, the project should be abandoned and the
Electricity tariff 0.10543 USD/ 0.0811 USD/ 0.05677 USD/ investment for the construction and operation phase declined.
kW h (130%) kW h (100%) kW h (70%)
O & M costs 0.008281 USD/ 0.01183 USD/ 0.015379 USD/
Otherwise, the project would continue. At node 2, execution of the
kW h (70%) kW h (100%) kW h (130%) option at the expense of US$10 million to fund the design phase would
Efficiency of 100% 82.56% 57.79% generate an option for the construction and operation phase. This
Energy would produce the option value of US$21.3 million. However, at node
Production
3, the economic situation is not favorable for the investment, so the
CER price 25.38 USD/tCO2 12.70USD/tCO2 0.02 USD/tCO2
(Jul. 2008) (Dec. 2014) project is abandoned. At year 2, the investor makes a final decision
regarding whether to advance to the phase of construction and

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K. Kim et al.
Fig. 3. Cash flow of the case study project under the moderate case.
operation. If the project turns out to be economically feasible, as shown
at nodes 4 and 5, the investment is executed. When examining nodes 4
and 5, node 4 presents a more ideal situation, as the option value is US
$48.2 million, with the cost of US$140.1 million. At node 5, the option
value is only US$ 1.3 million. However, at node 6, representing the
worst case, the project is considered to be unfeasible and investing in
the construction is declined. The project NPV calculated in the
traditional way was US$6.3 million under the moderate scenario.
Since the SNPV was US$12.6 million (twice the value of the NPV)
the real option premium was US$6.3 million.
In step 4, for sensitivity analysis of the four key variables affecting
the option value of the case study project, a Monte Carlo simulation of
100,000 iterations was conducted. Each variable was assumed to have a
triangular probability distribution, with the maximum, minimum, and
mean parameters assumed to be equal to the best, worst, and moderate
values. The sensitivity analysis showed that tariff (51.4%) was the most
influential factor, followed by energy production (39.5%), CER price
(7.0%), and O & M cost (−2.2%) as shown in Fig. 8. The sensitivity
outcomes of tariff and energy production totaled more than 90%,
meaning that these two factors strongly impacted the option value of
the case study project. Also, the CER price creates additional value only
in developing countries. However, O & M cost negatively influenced the
option value. In brief, the sensitivity analysis of the case study showed
that investors must focus their attention on improving tariff and energy
production to effectively increase profitability.
Fig. 4. Historical CER price in ECX of ICE (EU).
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Renewable and Sustainable Energy Reviews 75 (2017) 918–926
5. Conclusions
The two objectives pursued in this study were: (1) the uncertainties
in the RE projects of developing countries were estimated, and (2) the
economic feasibility of investments in such projects were assessed. An
ROA framework, a decision-making tool to evaluate RE project
investments in developing countries, was proposed to achieve these
objectives. The framework utilizes the key variables of the RE projects
particularly in developing countries to capture the project uncertainty
through volatility estimation. This study considered the following key
variables that directly influence the projects’ profitability: tariff, energy
production, CER price, and O & M cost in a RE source. The ROA
framework yields numerical results to help investors make decisions
regarding the feasibility of the RE projects in developing countries.
With the compound option of the proposed framework, investors hold
the option to fund or abandon the project in each project stage. A case
study of a hydropower project in Indonesia was conducted, and the
project was divided into multiple phases including planning, design,
and construction and operation stages. The case study proved that the
compound option effectively reduced risks and maximized profit, by
offering three investment decision opportunities. The decision makers
could decide whether or not to invest in every stage, as long as the
market uncertainty could be manageable. Consequently, it is shown
that the proposed framework properly reflects the uncertainties and
assesses the economic feasibility using ROA. Thus, the two objectives of
this study were successfully accomplished.
This paper provides significant contributions regarding the applica-
K. Kim et al.
Fig. 5. Returns of the case study project under the three scenarios.
Fig. 6. The compound option model of the case study project.
tion of ROA to RE projects in developing countries. First, a ROA
framework was proposed that is applicable to various kinds of RE
sources and the entire process of investment for RE projects in
Fig. 7. The binomial lattice for calculation of the compound option.
924
Renewable and Sustainable Energy Reviews 75 (2017) 918–926
developing countries. The framework is an effective tool for assessing
the investment's economic feasibility, since it considers the uncertain-
ties associated with RE projects in developing countries. Secondly, a
compound option model was designed to consider multistage invest-
ment timing for the planning, design, and construction phases.
Application of a compound option for investment in RE projects
strengthens the originality of this study. It has an advantage in
adequately managing the uncertainties that are derived from climate
change and the economic instability of developing countries. The
project value is improved by holding the options to hedge from losses.
Third, the four key variables that were identified in this study can be
utilized in any type of RE projects and serve as apposite factors in
related assessments. The three-point estimation was used as a means to
evaluate the volatility of project cash flows incorporated with the key
variables. This approach is based on rational reasoning accompanied
by available data and experience. Although it may not yield mathema-
tically precise results, it can still be utilized as a practical and
convenient tool for estimating the volatility of RE projects without
requiring complex computations and elaborate historical data.
A case study regarding an Indonesian hydropower project provided
meaningful findings on RE investment. A sensitivity analysis deter-
K. Kim et al.
Fig. 8. Sensitivity analysis for option value of the case study project.
mined which variables had the greatest influence on the project value.
To maximize the profit of RE projects in developing countries,
investors should take into account the following order of priority
among the variables: tariff, energy production, CER price, and O & M
cost. Investors should focus their attention on improving the project
factors of tariff and energy production because they could account for
90% or more of the option value. Tariffs are usually developed through
negotiation between the host government and the investors, whereas
geographical features, regional climate conditions, the type and level of
technology, and even global climate change influence energy produc-
tion. Thus, investors should carefully investigate the whole range of
input elements and try to find and use the ideal combinations of these
elements. In conclusion, the proposed ROA framework can be used as a
tool for making investment decisions in the volatile RE market in
developing countries.
More accurate quantification of project uncertainty will be an
important area of future study, to allow for better management of the
risks and uncertainties of RE projects in developing countries.
Although much remains undetermined about how the uncertainties
of RE projects and developing countries will fluctuate with climate
change, environmental policies, and economic status, valuation meth-
odology of RE projects should continue to incorporate state-of-the-art
science to support investment decisions. The proposed model, if
strengthened by, for example, more accurate climate scenarios or big
data analysis approaches, could be expected to significantly contribute
to the value increase of RE investment in developing countries.
Acknowledgments
This work was supported by grants from the National Research
Foundation of Korea (NRF), funded by the Korea government (MSIP)
(No. 2011-0030040 and NRF-2014R1A2A1A11052499). We would
like to thank the following colleagues for their helpful discussions
regarding the application of ROA to RE projects: Sooji Ha, Seongdeok
Bang, and SungJae Park of the Advanced Infrastructure Management
(AIM) group of Yonsei University.
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