Real options with regulatory policy uncertainty

Abstract

Energy Finance as a field is particularly bedeviled by regulatory uncertainty. This is notably the case for the real option analysis of long-lived energy infrastructure. How can one decide optimal build times on a 50 year project horizon when regulations regarding pricing and costs change on a much shorter time scale? In this paper we present a quantitative framework for modelling and interpreting regulatory changes for energy real options as a Poisson jump process, in a context where other relevant prices follow diffusion processes. We illustrate this conceptual framework with a case study involving the US corn ethanol market for which subsidy levels have experienced frequent changes. Subsidy levels have an easily quantified impact on operations and profitability, making this a nice arena to introduce ideas which might later be extended to less easily quantified regulatory changes. Numerical techniques are presented to solve the resulting partial integro differential variational inequalities. These solution techniques are deployed to solve instructive numerical examples, and conclusions for public policy are drawn.