Water Resources and Technology Investment Under Uncertainty

Abstract

Supporting thermoelectric power generation requires a significant quantity of water, primarily for cooling operations. Lack of available water due to physical scarcity or thermal permit limits associated with the Clean Water Act 316 (a) can result in a forced curtailment of plant operation, known as a “derating event.” Depending on the duration and severity of this derating event, a utility can realize millions of dollars in economic loss. To prevent such events, a power plant can invest in alternative cooling technology that reduces the plant’s dependence on large quantities of water for cooling operations. Such investments however, may be difficult to justify due to large capital costs for water conservation technologies and highly uncertain future cost of derating events - future derating costs are a function of climate and energy market prices. Thus, the capital decision to invest is complex. Traditional valuation approaches, like Net Present Value (NPV) analysis, are unable to properly value irreversible investments in environments of high uncertainty because they fail to account for managerial discretion and flexibility in investment. Real options analysis (ROA) has been proposed as a promising solution to the deficiencies of traditional valuation methods when facing risky technology investments or ventures. The valuation technique, rooted in financial option theory, incorporates “Real option thinking” - the managerial flexibility to capitalize on opportunities as they arise and minimize the impact of threats - is precisely what is needed when faced with the uncertain future of irreversible technology investments. This paper applies ROA to an evaluation of the investment in water saving cooling technology at the Allen Steam Station in the Catawba River Basin of North and South Carolina. The results indicate that the use of an NPV analysis leads to an undervaluation of the project because the option value - the value of managerial flexibility - is not included in the valuation. The flexibility of managers is an important criterion for making decisions regarding sunk cost investments and firms should evaluate investments with techniques that incorporate this option value.