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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