Managing Risk in Alternative Energy Product Development

We will explore how to value using modern financial techniques the development of new alternative energy technologies (AETs) given uncertainty. Uncertainty in developing AETs derives from: (1) the reduction in installation cost of new generation capacity as experience with the technology is gained, i.e. the learning curve (2) oil and natural gas price cycles; and (3) other macroeconomic and geopolitical forces, particularly the behavior of national oil companies (Aramco, PDVSA, PEMEX, etc.). Evaluating a new AET properly requires representing these uncertainties as well as an investment valuation approach that works well under high uncertainty. In particular, we propose to adapt the real options methodology to value the potential return from developing alternative energy technologies using stochastic system dynamics models representing the uncertainty in both the learning curve and the fossil fuel price cycles. The proposed algorithm to accomplish this valuation leverages the prior work on real options valuation in the decision analysis literature.