A real options based decision support tool for R&D

Energy Finance Christmas Workshop,

EFC 19, ESRI, Dublin12th – 13th December 2019

Peter Deeney1, Mark Cummins1 ,

Katharina Keintz2 and Mary Pryce2

1 DCU Business School 2 DCU School of Chemical Sciences

A real options based decision support tool for R&D investment: Application to CO2 recycling technology

Summary of Presentation

1. Scenario: R&D to produce an existing commodity

2. Discrete model for research progress

3. Variable rate of progress: early, late and operational

4. European and American Options

5. Application to CO2 Recycling

6. Results

Real Options and R&DUnderlying asset is difficult to value, as it is not usually

traded.

The strike price characterises a decision.

Better than NPV – future flexibility is included.

Ideal for R&D - future flexibililty

We use mean reversion for the commodity model and GBM for the emissions allowances.

R&D Progress

Chemistry

Discrete steps, discoveries, Poisson distribution, λ

Business

Measure progress as units produced per €,

UPC units per cost

Logistic Curve, an S-Bend

Consider R&D progress as the same shape as the logistic function, L(x).

Adapting the Curve

Basic Logistic Function adapted for a limit m with an affine transformation for the x variable.

Units per Cost = UPC(x), x = the number of discoveries

UPC function in new Variables

UPCMin = UPC at the start of the R&D Project;

x = number of discoveries

xR = discovery with rate of greatest improvement

m = maximum UPC possible

How close is a breakthrough?

For different types of projects

Maximum rate of progress at xR .

Summary of Presentation

1. Scenario: R&D to produce an existing commodity

2. Discrete model for research progress

3. Variable rate of progress: early, late and operational

4. European and American Options

5. Application to CO2 Recycling

6. Results

Three R&D Phases

Summary of Presentation

1. Scenario: R&D to produce an existing commodity

2. Discrete model for research progress

3. Variable rate of progress: early, late and operational

4. European and American Options

5. Application to CO2 Recycling

6. Results

Option Type

Early Phase

Fixed length of time, Proceed if costs are halved

Late Phase

Exercise when the market is ready

European

Compound Call

(on the late R&D)

American Call on Investment

Calculation List

What is the value of the late phase R&D?

We can estimate this at the start of the early phase or at the end when we

know how much progress has been made.

What is the value of the early phase R&D?

Late Phase R&D

Decision to go ahead to operational phase made whenever it is advantageous, therefore American

The underlying asset is the sum of the cash flows from the plant during operations.

The cost is the construction cost of the plant.

E[max{Operation Cash flow – Plant Cost, 0}]American

Early Phase R&D

Decision to go ahead to late phase at the end of the early phase R&D

Typically publically funded, fixed schedule and some target to satisfy a privately funded late R&D

European Compound option on the American option of the late phase

E[max{American Option from Late Phase –

American Option value if target reached, 0}]European

Summary of Presentation

1. Scenario: R&D to produce an existing commodity

2. Discrete model for research progress

3. Variable rate of progress: early, late and operational

4. European and American Options

5. Application to CO2 Recycling

6. Results

American Option Pricing

−Glasserman, 8.4

−Random Tree

−Upper and Lower Estimators

Recycling Carbon Dioxide into Methane using Sabatier Process

Income

Methane

Emission Allowances

Expenditure

Processing

Hydrogen / Electricity

Carbon Capture and Transport

Methane Production Costs

Hydrogen Production Costs

Learning by Doing

−CPU is cost per unit, the reciprocal of UPC

A is a constant

CP is the Cumulative Production

Parameters and Prices

Poisson per month : Early 1; Late 0.5;

LBD 1% per doubling

€40,000 to €1,636, xR =50, one year build, ten year plant life,

1. Production cost of product reduce R&D and LBD

2. Income from EUA , GBM with drift to €80 in 2028

3. Income from natural gas, mean reverting

4. Expense from carbon capture, reduce LBD

5. Construction costs €100m

6. Fixed costs €1m per month rising at 1% per month

7. Discount rate 3%

Gas Prices Mean Reverting Model

Carbon Prices GBM with Drift

Discounted Cash Flows

-3 000 000 000

-2 500 000 000

-2 000 000 000

-1 500 000 000

-1 000 000 000

-500 000 000

-

500 000 000

1 4 7

10

13

16

19

22

25

28

31

34

37

40

43

46

49

52

55

58

61

64

67

70

73

76

79

82

85

88

91

94

97

100

DCF for Various dTE

dTE DCF

Summary of Presentation

1. Scenario: R&D to produce an existing commodity

2. Discrete model for research progress

3. Variable rate of progress: early, late and operational

4. European and American Options

5. Application to CO2 Recycling

6. Results

Calculation List

What is the value of the late phase R&D?

What is the value of the early phase R&D?

Number of Discoveries at the Late of the Late Phase, Start = 30

Late Phase UPC Values

Monte Carlo Simulation

There are three stochastic sources

−Discovery (Poisson)

−Natural Gas Price (Mean Reversion)

−EUA Price (GBM with drift)

−This requires a large number of simulations

−Start with branching of 4 six times (4,096), to 16 branches six times (16,777,216)

Sensitivity

−If we have a 5% probability of complete loss during the R&D in addition to a 5% probability of loosing half of the income at some stage during operations, then the value of the early R&D drops by 17 % and the late by 13%

−If we do not have an S-Bend and use a straight line, then there is no upper limit to the improvement and the late phase R&D value jumps by 14%

−If the R&D proceeds in a deterministic fashion then the early R&D drops by 51% and the late by 54%, due to the lack of unusually high outcomes.

Early Phase Values

Value of Early Phase European Compound Option

€45.5m

Value of Late Phase American Option at the start of the process, before any research, t=0:

€87.4m

NPV was - €73.8m

Conclusions

Values for R&D are calculable

More needs to be done for parameters

Real Options produces a fairly high value for the R&D at the late stage and lower for the early stage

The method can be applied to any production process

Thank you for your attention,Merry Christmas

Peter Deeney

Mark Cummins

Katharina Heintz

Mary Pryce