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Optimal Investment in Energy Efficiency under Uncertainty

Keywords: Energy efficiency, Real options

Author(s): Luis M. Abadie, José M. Chamorro, Mikel González-Eguino

Date: 2009-18-11

Issue: 2009-11

  Download this working paper (539 KB.)

This paper deals with the optimal time to invest in an energy efficiency improvement. There is a broad
consensus that such investments quickly pay for themselves in lower energy bills and spared emission
allowances. However, investments that at first glance seem worthwhile are frequently not undertaken. Our
aim is to shed some light on this issue. In particular, we try to assess these projects from a financial point
of view so as to attract sufficient interest from the investment community. We consider the specific case of
a firm or utility already in place that consumes huge amounts of coal and operates under restrictions on
carbon dioxide emissions. In order to reduce both coal and carbon costs the firm may undertake an
investment to enhance energy efficiency. We consider three sources of uncertainty: the fuel commodity
price, the emission allowance price, and the overall investment cost. The parameters of the coal price
process and the carbon price process are estimated from observed futures prices. The numerical
parameter values are then used in a three-dimensional binomial lattice to assess the value of the option to
invest. As usual, maximising this value involves determining the optimal exercise time. Thus we compute
the trigger investment cost, i.e. the threshold level below which immediate investment would be optimal.
A sensitivity analysis is also undertaken. Our results go some way towards explaining the so-called energy
efficiency paradox.

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