DISCOUNTED CASH FLOW AND OPTIONS
THINKING APPROACHES APPLIED TO CLEAN
ENERGY INVESTMENT – THE CASE OF CCS
Chi Kong CHYONG
David REINER
Danny RALPH
CUEN Seminar Series – 25 Feb 2013
Background and Overview
• Valuation methodologies like Discounted Cash Flow (DCF) do
not, on their own, offer an explicit way to incorporate uncertain
future market or policy conditions that could have asymmetric
impacts on investment performance into valuations.
• Nor do they account for managerial flexibility to respond as
uncertainties are resolved.
• Clean energy investments are particularly exposed to this set
of conditions, so such tools could lead to suboptimal
investment decisions if not used appropriately.
• We conclude that where these conditions of uncertainty exist,
enhancing valuation methodologies with approaches that
explicitly value embedded optionality to respond should
become standard practice. This would formalise some existing
market practices.
Background and Overview II
• Options analysis explicitly treats and acknowledges
uncertainties and strategic investment decisions contingent
on evolution of key uncertainties
• Therefore, our research objective was to examine: “under
what circumstances traditional DCF analysis understates the
option value of clean energy investment decisions”
• Three clean energy investment case studies were analysed:
• Natural gas power generation plant with post-combustion carbon
capture technology
• Offshore wind farm investment in the UK North Sea
• Onshore wind farm investment in the US Midwest region
• We present the CCS case here, but the full analysis is at:
http://www.cpsl.cam.ac.uk/bei#fragment-4
eady exist and are used in both the investment and energy industries (either formally or
ly), but their diffusion is still not as wide as is desirable. Figure A illustrates the conceptua
ce between valuation methodologies that do, and do not, explicitly value optionality and
ts the potential value of that optionality.
Why Options Analysis?
Probability
NPV without optionalities
(i.e. DCF value)
Expanded NPV with
optionalities
Value of optionality
0
Profit
eed to
wer
na
atory
we
I's real
s can be a
emental
managers,
d financial
allocate
Real
s, when
ha
counted
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ture value
mes that
uld be lost
ojects that
(DCF) analysis, so it should not be seen as a separate, or particularly more
complicated methodology. Equally, Figure 5 unpacks what is sometimes viewed as
an opaque process.
How to Use Options Analysis
r, Head of
ch EMEA,
Qualitative
asset/project(s)
screening &
analysis
Input data &
assumptions
Discounted
Cash Flow
Analysis
Traditional
valuation
approach
Distribution of
NPVs and Expected
NPVs
Sensitivity
analysis
Identification of
strategic
optionalities
Options
valuation
Net Present
Value
Expanded NPV
(NPV + Optionsa
o
Value)
Reporting &
results
presentation
Options
thinking
approach
vestment valuation methodologies. These circumstances are present for a range of clean en
logies, in a range of markets. An options approach should not replace traditional DCF analy
mplementary tool to help improve decision-making under challenging conditions.
When to Use Options Analysis?
Use traditional valuation
methodology (eg DCF)
Enhance valuation
methodology with an
options approach
Uncertainty is limited and
can be credibly quantified
Uncertainty is significant
and cannot be credibly
quantified
Shape of probability
distribution of future
market conditions
Close to symmetric
Asymmetric, with the
possibility of high-impact,
low-probability events
Management flexibility to
change strategy in response
to new information
Management flexibility is
low; investment problem
does not have optionality
embedded
Management does have
flexibility; investment
problem has optionality
embedded
Valuation methodology
Conditions
Degree and nature of
uncertainty around future
market conditions
Evidence of Asymmetries in Key Variables
(Henry Hub Gas Price 2003-2012)
-2σ
2σ
DCF valuation without further quantitative or qualitative assessment may now be
performing very differently compared to original expectations.
More Evidence of the Dangers of Forecasting
8
io in 2010
Actual price
7
US$/MBTU
6
5
2010
4
2015
3
2020
2
1
0
AEO09
AEO10
AEO11
Sources: US Energy Information Administration (EIA), Annual Energy Outlook (AEO) for 2009, 2010 and 2011
Key Principles
Traditional discounted cash flow analysis is unable to reveal strategic
project value embedded in optionality in light of great uncertainties
• Traditional valuation (such as DCF): present value of Benefits
less Costs
• Highly sensitive to weighted average cost of capital
(discounting):
• WACC depends on many factors, such as default premium, inflation
premium, CEO’s strategic decision-making ability (options thinking), etc.
• Issue: projects with high uncertainties, such as clean energy
investment, are penalised with much higher WACC because
of high uncertainties; but uncertainties ≠ risks.
• Therefore, capital markets put an unjustifiably high premium
on clean energy investment. However…
Key Principles
…Not all uncertainties are risk, and not all risk is bad
• Uncertainties have both downsides as well as upsides; thus,
uncertainties are both risks and opportunities
• Given ability to make strategic investment decisions contingent
on evolution of these uncertainties, we can capitalise
opportunities and minimize risks embedded in uncertainties
• Thus, options have strategic value when there are uncertainties
- -> Higher uncertainties increase the options value
• Options analysis adds another analytical layer on top of DCF to
better value and reflect strategic nature of decision making
under uncertainties
Carbon Capture and Storage for Natural Gas
Power Plant in the UK: Inputs & Assumptions (1)
• Decisions:
• Power plant investment
• CCS (post-combustion) NGCC?
• Carbon Capture ready (CCR) NGCC?
• Non-CCR (Baseline) NGCC?
• Capture plant retrofit (for CCR & non-CCR options):
• every two years
• Uncertainties:
• Gas price & Electricity price (stochastic)
• CCS Learning rate (stochastic)
• Carbon price (scenarios)
• Timeframe: 2013-2033
CCS Decision Tree
Carbon Capture and Storage for Natural Gas Power Plant in
the UK: Inputs & Assumptions (2)
Pipeline
CAPEX, £mn
OPEX, £mn/year
Storage
CAPEX, £mn
OPEX, £mn/year
139
12.6
74.2
12.8
Valuing Carbon Capture Readiness (CCR) Option
Definition & Assumptions
• Baseline NGCC is required by the UK law to demonstrate capture readiness, but
in essence:
• Demonstrate technical ability to retrofit (i.e. engineering report) & enough
physical space
• CCR option costs £3mn (on top of the baseline NGCC), includes:
• Space and foundations reinforcement for turbines
• Engineering design to accommodate new solvents & ability to export additional
power (from reduced power requirement for solvent regen & CO2
compression)
• Thus, CCR can be viewed as an option which gives a power generator the right
(but not the obligation) to retrofit the power plant with CO2 capture on or before a
future date (the exercise date or expiration).
• Given engineering design of the CCR option, its value depends on expectations
of CCS deployment in the future, carbon prices & uncertain CCS technology
learning. Thus, CCR options value = eNPVCCR – eNPVbaseline – InvCostCCR
Carbon Capture and Storage for Natural Gas Power Plant in the UK
Inputs & Assumptions (3)
• Parameters for modelling gas prices
(stochastic process):
• Estimated price volatility: 4%
• Assumed growth rate : 0.06%
• Parameters for modelling power prices
(stochastic process):
• Estimated price volatility: 7.6%
• Assumed growth rate : 0.3%
Cost of Equity
Risk-free rate (10Y UK Government
Bond)
Beta
Market Risk Premium
Cost of Equity
Mid-year factor
4.00%
0.51
6.00%
5.03%
102.48%
Tax, Inflation and Depreciation
Inflation rate
2.40%
Tax rate
23%
Depreciation method
straight line
Annual Asset Depreciation
5%
Carry Forward if no income to
depreciate
yes
Scenarios for the CCS case study
Carbon prices
• Carbon price paths:
• Base case: corresponds to the UK
carbon price floor
• Low C-price case
• High C-price case (‘Katrina-type’ of
hurricanes are more often by 2020)
• Carbon price effects on
wholesale electricity price (‘pass
through’ effect):
• 0% (no effect);
• 23% - DECC’s average assumption
(i.e., £1 increase in C-price increases
wholesale price by £0.23)
• 50% (i.e., £1 increase in C-price
increases wholesale price by £0.5);
• 100% (£1 increase in C-price
increases wholesale price by £1) 
this is possible if we believe that fossil
fuel generation will dominate the
electricity system in the UK (no
renewables)
DECC’s projection of Carbon and
wholesale electricity prices (2012-2030)
Scenarios for the CCS case study
CCS technological learning
• CCS technological learning:
• Improvement in capture efficiency
• Reductions in CAPEX & OPEX of a capture
plant
• Technological learning depends on:
• Learning rate (tables on the right); modelled
stochastically
• Global CCS deployment; deterministic
scenarios according to the following
deployment scenarios (tables on the right)
• Central Case for the analysis includes:
• Base case C-price
• DECC’s assumption regarding the effect of C-
price on wholesale electricity price (23% pass
through)
• Base case CCS technological learning:
• Base case rate of global CCS deployment & Base
case learning rates for capture efficiency
improvements and cost reductions
Learning rate scenarios: Efficiency of
Capture
Min
Max Most likely
High
11% 18%
15%
Base*
4%
6%
5%
Low
2%
3%
3%
* Based on survey of literature
Learning rate scenarios: CAPEX of
Capture
Min
Max
Most likely
High
18%
51%
33%
Base*
6%
17%
11%
Low
3%
9%
6%
* Based on survey of literature
Learning rate scenarios: OPEX of Capture
Min
Max
Most likely
High
30%
90%
66%
Base*
10%
30%
22%
Low
5%
15%
11%
* Based on survey of literature
Global CCS deployment rate (% pa): 2013-2033
High
40.00%
Base
10.00%
No CCS
0.00%
IEA (2010) assumes global deployment of 470 GW of
powergen with CCS by 2035 (70% of all coal
generation), or 17% p.a., in its most ‘optimistic’ CCS
scenario
CCR Investment as a
Hedge under Different
Carbon Prices
and Learning Rates
Conclusions
CCS Case study
• In general, gas power plants (and gas with CCS) in the UK
seem to be priced out of the market by the UK’s carbon
price floor unless carbon costs can be passed through to
consumers (which partly depends on the deployment of
renewables in the UK).
• CCR optionality has minimal impact in the high profit (low
carbon price) scenario, but provides a significant benefit for
the lower profit (base and high carbon price) scenarios
• A natural next step is to conduct a portfolio analysis where
we would, for example, value CCS and wind and other lowC generation technologies (e.g., nuclear)
• THANK YOU FOR YOUR ATTENTION!