Assessing carbon mitigation projects using real options valuation

16 Dec 2010Archived News Climate Change Matters

Options pricing models are a proven approach to valuing money spent today on real options, against the future value of these options to the business.

Real carbon options as a business planning tool utilises options theory to model resource and energy outcomes and projects. The use of real options ensures choices are not unduly limited and provides flexibility for long term planning purposes. While it is clear that carbon will be a cost to business, a national method for pricing carbon has yet to be determined. Carbon trading and climate change policies generally are in a state of flux therefore creating uncertainty for business planning and investment.

Building flexibility through a rigorous options methodology opens up a number of pathways and enables business to be more responsive to shifts in government policy by assisting them to make those decisions which ensure that a desired level of flexibility in responses is still available.

Some options identified may require little practical preparation and simply a business case to define the option which this project represents; other projects may require investment, for example, to secure access to land or equipment, rework a current process, or to reroute a new project to keep a site available before they can be considered as potential options.

Black & Scholes option pricing tools can provide a simple and well proven model for valuing the money spent today to secure the real option versus the potential future benefit. In options terminology, the work and cost to secure the project is the “option premium”. The cost to undertake the project is the “option strike price” and the financial benefit is the “option payoff”.

Building real carbon options

Energetics has developed a simple four step strategy for building and assessing carbon options.
1. Identify the opportunities: the carbon reduction and carbon offset opportunities, as well as the benefits that can be derived from carbon trading.
2. Assess project performance: scoping the potential projects, understanding the costs and practical considerations, and estimating the emissions reductions that can be achieved.
3. Plan the most promising and practical carbon projects: developing detailed project overviews and plans.
4. Secure the option: understanding the necessary steps to securing the right to undertake a project at the discretion of management. This may be as simple as developing the business case and project plan, or it may require securing land, equipment, people or other resources. This is the point at which a project becomes an option, when it is developed to the point that management can take a decision on whether it is sensible to exploit the project further.

The time and money spent on this phase is the option ‘premium’ that buys the business the right to exercise the carbon option at a future date. The options valuation model from financial markets can be a very helpful tool for evaluating the future cost benefit of this premium.

Business cases need to include the impact of a carbon price on the project.

Examples of real carbon options

  • Identifying local wind power sites and projects
  • Securing co-generation power sites
  • Trialling gas-powered vehicles
  • Investigating electric mining site vehicles
  • Exploring power generation from coal mine waste methane

Every business has opportunities for carbon reduction, and many businesses have opportunities to benefit from the introduction of carbon trading. An options approach to projects can help companies prepare for deployment under emerging policy settings. The ability to respond rapidly can provide a market advantage if a business can act ahead of its competitors. For example, at a carbon price of $20 per tonne it might become economically feasible for company A to implement a methane scavenging project. The lead time on ordering the equipment for this project is 24 months. Companies need to determine whether there is greater value in placing the order for this equipment now and potentially losing any deposit paid and being prepared for the introduction of a carbon tax on the waste gas, or whether they will bear the cost of acquitting their carbon liability for the waste gas if a trading scheme is introduced for the time that it takes to order and install the equipment. 

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