Energy Real Options: Valuation and Operations

Nicola Secomandi and Duane J Seppi

The ability to recognise and exploit flexibility is a fundamental source of economic value. In finance, flexibility is called an option. Optionality comes in many forms. Some options, like bond covenants and exchange-traded calls and puts, are legal constructs created by contractual counterparties to facilitate risk transfers. However, much of the optionality in the global economy is not contractual but operational. Growth options to enter a new market or to expand existing capacity, timing options to switch from R&D to production, and physical optionality in factories and other production infrastructure are known as real options. There is a large literature on pricing and managing various types of options.¹¹ixit and Pindyck (1994) and Trigeorgis (1996) are seminal introductions to real options. Grenadier (1996, 2002) introduce the concept of timing options and multi-party entry games. Geman (2005) is an introduction to commodity derivatives in general, and Clewlow and Strickland (2000), Eydeland and Wolyniec (2003) and, more recently, Secomandi and Seppi (2014) are introductions to energy derivatives in particular.

Storage, transportation, processing, refining and production of