Exploring the Value of the Option of Postponing an Investment Decision for a Coal-Fired Power Plant in Need of Meeting Air Emissions Standards

Inflexible performance or technology standards targeting CO2 emissions reductions from existing coal power plants would force investors to either retrofit units with CO2 emissions control equipment or retire them. However, at present neither retrofit nor replacement technologies are ideal. Investments happening today will reduce demand for breakthrough electricity generation technologies that may be just a few years away from becoming an alternative. What if rather than being compelled to make an immediate decision (i.e. to retrofit or replace) power plant owners could pay a fee to have the option of postponing their decision for a few years? If a breakthrough technology becomes commercially available during the waiting period, investors would have the option of using it and this would lower the overall levelized cost of electricity and cumulative emissions over the lifetime of the plant. This project explores the value that investors should be willing to pay for the option of postponing their investment decision. This report first provides a brief discussion of the compliance options (including retrofitting the existing power plant and replacement by a NGCC plant) for a hypothetical power generator in need of reducing 30% of emissions from its fleet of three coal-fired power plants. The second section presents a short literature review of the use of real-options valuation and dynamic programming for the valuation of power generation investments. The third section, describes two models used in the project; a Monte-Carlo Simulation model and a Binomial Lattice-Like model, and presents the analysis performed for choosing the parameters and simulating the random variables representing fuel prices and technological change in the Monte-Carlo model. The Monte-Carlo Simulation model is used to calculate the impacts of compliance fees on the investment decisions which include the timing of the investment and the choice of generation technology. Using this model, two metrics, the 1% Upper Threshold Value Fee (UTVF) and 1% Lower Threshold Value Fee (LTVF) are introduced to measure the impact of compliance fees under different assumptions on the arrival rate of technological change. The Binomial Lattice-Like model is used to derive the value of flexibility by postponing the investment. The last section presents results for the hypothetical case discussed. Given the assumptions, there are 14 investment strategies available for the investors in terms of the timing of the investment and choice of technology. Two investment matrices reporting the mean and valueat-risk (VaR) at 5% of the Levelized Cost of Electricity (LCOE) for each of the 14 investment strategies are used to compare the two main compliance approaches, namely, to retrofit one of the three coal plants with CCS or to replace two of the coal plants with NGCC plants. Though the NGCC strategy has a lower expected LCOE, its VaR at 5% of LCOE is higher than the Retrofit (strategy). Thus, the NGCC strategy is better on average, but it can be very expensive when natural gas prices are high. The value of having the option to invest is affected by uncertainties on fuel prices and technologies. Looking at each source of uncertainty separately and in combination provides insights about the value that investors would be willing to pay to delay investment. For the base-case assumptions of the lattice-like model applied to the hypothetical investor, it is found that the value of postponing investment (i.e. the value of investment flexibility) under 1) technological uncertainty, 2) fuel price uncertainty, 3) and combined technological and fuel price uncertainties is $2.14/MWh, $6.28/MWh, and $7.10MWh respectively.