The use of real options valuation methodology in enhancing the understanding of the impact of climate change on companies

Copyright © 2009 John Wiley & Sons, Ltd and ERP Environment

* Correspondence to: Emily Tyler, MCom. Financial Management (Cape Town); B.Com Hons Economics (Cape Town), Climate Change Practice Manager, Genesis Analytics, 4 Bushwood Road, Little Mowbray, 7700 Cape Town, South Africa. E-mail: [email protected]

Business Strategy and the EnvironmentBus. Strat. Env. 20, 55–70 (2011)Published online 28 December 2009 in Wiley Online Library(wileyonlinelibrary.com) DOI: 10.1002/bse.668

The Use of Real Options Valuation Methodology in Enhancing the Understanding of the Impact of Climate Change on Companies

Emily Tyler1* and Richard Chivaka2

1 Genesis Analytics, Cape Town, South Africa2 Department of Accounting University of Cape Town, South Africa

ABSTRACTClimate change has in recent years gathered traction on the business, political and social agenda. From the business perspective, research has shown that climate change impacts on company value are uncertain, signifi cant and strategically important. The challenge therefore is for the business community to apply fi nancial valuation models that support the incorporation of the climate change impacts in strategic planning. However, the com-monly used discounted cash fl ow techniques in capital budgeting are seen as failing to address the high levels of uncertainties inherent in climate change impacts. Real options thinking has been touted as having the potential to enhance understanding of these impacts via its direct handling of uncertainty, although not much research has been done to dem-onstrate this. Using an illustrative case study, this research presents an argument for introducing the real options approach, a new method for valuing options of future strategic action by companies in a setting that exhibits climate change impacts. The objective of this research is to contribute to the literature on strategic tools for addressing climate change and ultimately offer some management insights that can narrow the gap between fi nance theory and business practice. Copyright © 2009 John Wiley & Sons, Ltd and ERP Environment.

Received 24 December 2008; revised 30 September 2009; accepted 5 October 2009

Keywords: climate change; fi nancial valuation techniques; real options; discounted cash fl ow; case study; clean development

mechanism; strategic investment; biomass power generation projects

Introduction

CLIMATE CHANGE, AND ITS SOCIO-ECONOMIC AND POLITICAL IMPACTS, HAS GENERATED A LOT OF INTEREST IN TODAY’S

global environment. Not only is climate change a favourite current topic in the scientifi c community and

political realm, its impact on every facet of humankind is seen as signifi cant. We have recently witnessed

the conferment of a coveted global award – the Nobel Peace Prize – on Mr Alfred Gore for his Inconvenient Truth documentary, which highlights the pervasive socio-economic and political impacts of climate change.

56 E. Tyler and R. Chivaka

Copyright © 2009 John Wiley & Sons, Ltd and ERP Environment Bus. Strat. Env. 20, 55–70 (2011) DOI: 10.1002/bse

In the business arena, climate change affects companies directly through its physical manifestations (fl oods,

drought etc) and indirectly via the need to reduce anthropogenic greenhouse gas emissions, which are causing the

problem. In turn, these impacts have knock-on effects on a company’s reputation and investment risk profi le. The

economic impacts of climate change have been found to be material and far reaching (Gars and Volk, 2003; Stern,

2006), and are predicted to result in a signifi cant change to the international business environment as it currently

exists (Cogan, 2004). The actual mechanisms through which climate change impacts are translated into value

impacts are wide ranging and complex (Austin and Repetto, 2000; Austin and Sauer, 2003; Gars and Volk, 2003).

Different sectors will be impacted to greater and lesser degrees; a 2006 survey on climate change conducted by

the Carbon Disclosure Project (CDP) has shown that at least 15 business sectors1 are at ‘high risk’ from climate

change (Innovest, 2006). Impacts on individual companies within these sectors have also been shown to fare very

differently according to their location, traditional sources of competitive advantage, existing asset portfolio and

management capabilities (Austin and Repetto, 2000; Austin and Sauer, 2003; Austin et al., 2003; Innovest

2003–2006), with climate change presenting a potential source of competitive advantage for many companies

(Kolk and Pinkse, 2004). A company’s strategic response to climate change has been found to be an important

determinant of its value in the future (Austin et al., 2003; Gars and Volk, 2003; Lippincot Mercer, 2004; Barker,

2004; Sauer and Wellington 2005; Innovest, 2005).

In addition to the strategic implications, climate change impacts on business have also been found to be highly

uncertain (Earle and Rhodes, 1995; Reed, 1998; Toman, 1998; Austin and Repetto, 2000; Austin and Sauer, 2003;

Heal and Kristom, 2002; Austin et al., 2003; Gars and Volk, 2003; Sauer and Wellington, 2005; IEA, 2006; Stern,

2006). This is congruent with the large ranges given by the latest scientifi c and economic reports, forecasting

a global temperature rise of between 1.8 and 4.0 degrees Celsius as a result of climate change (IPCC, 2007),

and a global average reduction in economic consumption per head as a result of its impact of between 5 and 20%

(Stern, 2006) respectively.

Climate science, although developing at an increasingly rapid pace, is still a relatively new and very complex

area of research. Whilst the high level fi ndings of changes in weather patterns and ecosystem response is

clear (IPCC, 2007), the detailed impacts on different geographical areas and the speed of these impacts are

still relatively unknown. So too, as governments grapple with the implications of climate change mitigation for

their countries, economies and political longevity, regulation and policy remain very unclear. These sources of

uncertainty make management decisions with regard to the future of corporations very diffi cult. With specifi c

reference to the private sector, climate change impacts make is very diffi cult to deal with two of the most important

fi nancial decisions, namely investment planning and risk mitigation. This is especially true for companies

oper ating in countries not identifi ed as Annex 1 of the Kyoto Protocol,2 which experience even greater policy

uncertainty.

As such, the impact of climate change on company value has been shown to be material, strategically important

and highly uncertain (Austin and Repetto, 2000; Austin et al., 2003; Gars and Volk, 2003; Lippincot Mercer,

2004; Sauer and Wellington, 2005; Innovest, 2003–2006). Being material implies that these impacts cannot be

ignored. More so, the fact that these impacts are strategically important may mean the difference between the

demise of a corporation on the one hand, and signifi cant growth through exploiting new sources of competitive

advantage. New sources of competitive advantage may be in the form of new business opportunities and/or new

ways of leveraging the existing assets. However, being highly uncertain implies that climate change makes it very

1 2006 CDP cited the following: automobiles and auto components, banks, diversifi ed fi nancials, beverages and tobacco, food products, food and drug retailing, chemicals (diversifi ed and specialty), electric power North America, electric utilities international, insurance, industrial conglomerates, industrial machinery, integrated oil and gas, metals and mining, and steel. In South Africa, an analysis of the Johannesburg Securities Exchange Top 40 companies for the South African CDP 2007 cited the following as ‘high risk’ sectors: automobiles and components, aerospace and defence, chemicals, construction materials, electric utilities, energy equipment and services, oil, gas and consumable fuels, metals and mining, paper and forest products, transportation, banks and diversifi ed fi nancials, beverages and tobacco, food products, and food and drug retailing, industrial conglomerates and industrial machinery, industrial products and services, and insurance (Tyler, 2007, p. 24).2 Countries identifi ed as Annex 1 to the Kyoto Protocol are those industrialized countries that have committed to absolute emission reduc-tion targets in the First Commitment Period of the Protocol, 2008–2012. This is distinct from non-Annex 1 countries, a set of developing economies, which are not subject to such targets.

Understanding the Impact of Climate Change on Companies 57


diffi cult to make predictions of important variables required in undertaking valuation analyses of future projects/

investments. Of particular interest to management would be (i) cash fl ow projections and (ii) risk profi les of

future projects. Due to the uncertainties arising from climate change, making cash fl ow pattern projections is not

only challenging, but potentially fraught with signifi cant deviations consistent with the large ranges given by the

latest scientifi c and economic reports. Compounding the situation is the diffi culty in making sound risk profi le

predictions of future investment projects due to the lack of consistent scientifi c predictions. This makes it very

challenging for management to peer into the economic situation beyond the immediate horizon and understand

the concomitant vagaries. Without reasonably accurate cash fl ow pattern predictions, and a more informed grasp

of the risk profi les of future investments, management cannot make sound judgements about the portfolio of

investment projects to pursue. This negatively affects a company’s strategic response to climate change, which is

argued to be a major determinant of its future value. Having better tools to capture the dimensions and chal-

lenges presented by climate change may assist companies not only to weather the economic vicissitudes, but

also to exploit the potential sources of competitive advantage embedded in climate change. However, in order

to inform company and investor strategy on climate change, its impacts on company value need to be fully

understood, described and measured. As such, this requires fi nancial valuation techniques that are able to

incorporate the particular dimensions and challenges that climate change presents to the valuation of assets and

companies.

Therefore, the challenge here is for the fi nancial community to provide fi nancial valuation analyses that have

the potential to support the incorporation of the economic climate change impacts in strategic planning. The realm

of fi nance, with its various capital budgeting techniques, provides the avenue by which climate change impacts

can be elevated to the strategic planning level. This is because capital budgeting techniques are designed to (i)

capture future cash fl ow patterns of investment projects, (ii) highlight the risk profi les associated with these invest-

ments and (iii) assist management in making sound judgements on investment strategies. However, the most

popular capital budgeting techniques in the form of discounted cash fl ow (DCF) analysis and other more traditional

valuation approaches demonstrate shortcomings in addressing the key characteristics of climate change impacts

(Austin and Repetto, 2000; Reed, 2001). These shortcomings, as will be discussed below, arise particularly due to

the high level of uncertainties arising from climate change that are not suffi ciently captured by DCF analytical

tools. An emerging valuation technique, real options analysis, shows potential to enhance understanding of these

impacts through its direct handling of uncertainty and strategic considerations (Austin and Repetto, 2000; Reed,

2001).

The aim of this paper is to investigate the application of the real options approach in a capital budgeting

decision that involves signifi cant uncertainties arising from climate change. The research therefore addresses

the following questions:

In what way does real options theory assist in handling capital budgeting uncertainties and strategic considerations arising from climate change?

What additional insights can real options theory provide over and above those provided by DCF when making capital budgeting decisions in areas that are prone to climate change impacts?

The objectives of this research are twofold, namely to (i) contribute to the literature on strategic tools, in the form

of a valuation technique, for addressing climate change and (ii) offer some insights that can narrow the gap between

fi nance theory and business practice. In order to achieve these objectives, the research demonstrates how real

options theory can be applied to provide a better understanding of the potential impact of climate change on the

value of business projects. In addition, it explores the potential usefulness of the real options approach in capital

budgeting versus the traditional DCF approach in the face of uncertainties and strategic considerations necessitated

by climate change. The rest of the paper is organized as follows: the following section deals with literature review,

followed by research design in the next section. The results of the research are presented in the fourth section,

while the fi fth section discusses the research implications and contributions. The conclusions and areas for further

research are presented in the sixth section of the paper.



Literature Review

Due to the centrality of uncertainty and strategic implications of the impact of climate change on shareholder

value, it is imperative that they be specifi cally taken into account in capital budgeting/project valuation approaches.

Reed (2001) scopes out a range of valuation techniques available to the 21st century analyst and attempts to apply

them to corporate sustainability strategies, which have many elements in common with a climate change response

strategy. He cites real options analysis as being ‘arguably the most potent emerging valuation methodology for

illuminating the value of corporate sustainability strategies’ (Reed, 2001, p. 2). Austin and Repetto (2000) also

propound the use of real options to augment a DCF framework for the strategic management of environmental

impacts.

Financial Valuation Techniques and Climate Change

The DCF valuation framework has dominated in climate change valuations (Austin and Repetto, 2000; Austin

and Sauer, 2003; Austin et al., 2003; Gars and Volk, 2003; Barker, 2004; Innovest, 2003–2006), as it has in

valuations in general. However, DCF analysis has been proven to fall short in circumstances of high uncertainty,

strategic importance and where management fl exibility is a key element (Ross, 1995; Damodoran, 2002; Mun,

2002; Wang 2002). Within the DCF framework, uncertainty has typically been dealt with through scenario

analysis, leading to results that are expressed as a range of possible shareholder value outcomes. Scenario analysis

is criticized as being limited from a valuation and strategic perspective in that it assumes a set of possible sce-

narios given information available today. Consequently, it disregards management fl exibility in responding to the

arrival of new information and a changing environment over time (Mun, 2002). The strategic implications of

climate change have to date been captured through the use of valuation techniques that focus on aspects such as

management quality (Austin et al., 2003; Gars and Volk, 2003) and brand value impacts (Lippincot Mercer, 2004),

not providing particularly useful tools for shareholders and management to understand and exploit strategic

opportunities arising from climate change. In addition, both DCF and its associated approaches are static approaches

to analysis, failing to capture the dynamic nature of business decision-making in an evolving environment. Real

options analysis has emerged in the past two decades as a technique for use in conjunction with DCF in strategic

investment decisions that are associated with high levels of uncertainty (Mauboussin, 1999; Reed, 2001; Wang,

2002; Mun, 2002; IEA, 2006). Real options analysis can be used both to value a company through a valuation of

its strategic business options, and as a strategic business tool in capital investment decisions (Mun, 2002). Given

theoretical support of real options in the fi nancial analysis of sustainability and environmental impacts (Austin

and Repetto, 2000; Reed, 2001), and the technique’s application to uncertainty and strategic issues, its application

to climate change is worth exploring further.

Real Options Analysis

The concept of the real options approach to valuations has been appearing in the academic literature for the past

15 years, with practical applications occurring in the past few years (Schwartz and Trigeorgis, 2004). The real

options analytical technique extends fi nancial options theory, developed by Black and Scholes (1973), Merton (1973)

and Cox and Ross (1976), to options on real assets. Owning a fi nancial option gives the investor the right, but not

the obligation to purchase or sell a security at a given price. Similarly, the owner of a real option has the right, but

not the obligation, to take up or divest an investment opportunity in a non-fi nancial or real asset at some time in

the future (Mauboussin, 1999). Thus, unlike traditional valuation methods, it accommodates a world where change

and uncertainty are pervasive, and business strategies and investments are constantly re-evaluated (Mun, 2002).

Real options analysis explicitly incorporates management fl exibility, which has been held to represent a substantial

part of the value of many projects (Schwartz and Trigeorgis, 2004). A typical example would be a real option

belonging to a mining company through its ownership of the mining rights to a piece of land. The company owns

the option to mine the land in the future should the economics of this activity, determined by the price of the



mined commodity and the extraction costs, prove attractive. This option is valuable in that it enables the mining

company to wait until more favourable circumstances arise before implementing the mining project. It also avoids

costly errors if there are unfavourable developments in the economy.

The example cited above constitutes an option to delay an investment until circumstances are favourable.

The option only exists as a result of the company’s ownership of an underlying asset, in this case the mining

rights to the land. While real options thinking was originally applied to the natural resource sector, it has

since been expanded to applications across the economic spectrum (Mun, 2002). Real options are embedded

throughout the assets of a company and come in a variety of forms including options to (i) expand, (ii) abandon

and (iii) switch product types or process technology. They also include compound options, where the option’s value

is dependent on the value of another option, rather than on an underlying asset (Kodukula and Papudesu, 2006).

Some of the most valuable applications of real options thinking lie in its input to strategy and the capital budget-

ing process. Awareness of an asset’s options has the potential to prevent loss due to management unknowingly

disposing of assets prematurely. Also, an understanding of options can provide useful technical support to manag-

ers when proposing more costly projects that have embedded value that traditional DCF approaches cannot

reveal.

Real options valuation solutions are theoretically very complex (Kodukula and Papudesu, 2006), and, as such,

a discussion of the theoretical underpinnings is beyond the scope of this paper. In summary, arbitrage principles

and the concept of futures markets for commodities are used to enable the valuation to be undertaken in a risk-

neutral environment. The option is valued relative to the underlying asset, and therefore has the same value in

the actual world as in the risk-free one (Schwartz and Trigeorgis, 2004). This risk neutrality enables all fl exibilities

to be properly incorporated into the analysis. The most common methods for real option valuation are closed form

solutions such as the Black–Scholes, partial differential equations and binomial lattice approaches (Mun, 2002).

A binomial lattice approach is generally favoured, given its transparency and intuitive appeal (Mauboussin, 1999;

Mun, 2002).

Real options generate their value from the following drivers. (i) The real option is more valuable the longer the

time until the option expires. Holding the option allows a company to wait until the arrival of additional informa-

tion before making a potentially costly and irreversible investment decision. (ii) The greater the risk of the project,

the more valuable the option is. Owning an option hedges against all downside losses, as the investor can simply

decide not to implement the project in unfavourable circumstances. However, the option holder still has access to

all potential upsides. This is contrary to conventional fi nance thinking, which holds that the higher the risk, the

lower the value (Mauboussin, 1999). (iii) Exclusive ownership of an option renders it more valuable than shared

ownership. For example, where a number of competitors have developed a new product, they share the option to

delay the product’s launch until a more certain demand environment exists. However, given market leadership

considerations, a patented product representing the exclusive ownership of the option by one company would be

far more valuable than the shared option. (iv) The greater the importance of the uncertain portion of the cash fl ows

is to the overall value of the project, the greater the option value.

Real options analysis is most usefully conceptualized as a complement to DCF analysis because it captures the

additional value arising from the optionality embedded in an asset (Mauboussin, 1999; Mun, 2002). The fi rst step

in a real options valuation is therefore to create a conventional DCF of the underlying asset that contains the

embedded option. In a mining company, for example, this would be the mining project under today’s economic

circumstances. From a real options perspective, DCF can be conceptualized as a special case, one that ignores the

potential for management fl exibility as additional information about the uncertain variables is received. Real

options analysis enables the additional value arising from this fl exibility to be described and quantifi ed. The value

of the option is then added to the DCF value to arrive at a more realistic assessment of the asset’s total value. The

use of real option value to complement conventional DCF value of assets and companies is held to be more appro-

priate due to the increasingly uncertain and changeable nature of today’s business environment. As such, real

options analysis is anticipated by some to become an important component of the valuation ‘toolbox’, if not the

dominant valuation paradigm, in the 21st century (Mauboussin, 1999; Mun, 2002; Schwartz and Trigeorgis, 2004;

Kodukula and Papudesu, 2006). A real options perspective can either be used to conceptualize and value existing

options, or to help management create options within projects that hedge risks, reduce maximum regret or

leverage an investment in an option many times over (Mun, 2002).



Application of Real Options to Climate Change Impact Valuation

The potential scope for the application of the real options approach to climate change impacts appears to be

extensive, with types of climate change related real options including the following.

� Options to switch from carbon emission intensive technologies and products to cleaner fuels, processes and

outputs as emission taxes and regulations become increasingly expensive.

� Options to ‘scope up’ (Mauboussin, 1999) by moving into related industries with a lower climate change exposure

as opportunities in these areas open up in response to climate change policies and consumer preference.

� Options to contract by reducing the size of high emitting operations as these become unfeasible due to high

carbon taxes or emission trading prices.

� Options to abandon high emission operations altogether in the longer term.

� Options to delay investment in a clean technology until market forces have proven its value or to delay projects

until prices for carbon credits or the extent of the physical climate change impacts justify investment, or

even to delay investment in a high emitting asset until imminent climate change related regulations are

known.

In addition to capturing the value from opportunities created by climate change and identifying the potential for

creating risk hedges, real options analysis can also put a value to the climate change risks themselves by modelling

a climate change insurance solution, which would then price the risk. For example, farmers can use weather

derivatives to hedge the risk of unexpected frosts. Real options thinking focuses on the value of a company’s ability

to respond fl exibly to climate change impacts as they emerge, as opposed to the net present value of the impacts

as best understood today. This is valuable in an area that is evolving as fast as our understanding of, and response

to, climate change. A real options perspective offers a potentially useful strategic tool for companies to incorporate

the impacts of climate change into their investment and strategic decision making processes, by incorporating

valuable climate change related options in capital budgeting exercises.

Real options analysis is unlikely to yield signifi cant insights in a fi eld where the option values arising tend to

be low, as these values are unlikely to result in any major changes in decision making when compared with that

undertaken using DCF alone. When considered against the drivers of real options value, the characteristics of

climate change impacts on companies suggest that climate change related options may have a high value. Climate

change is a long term phenomenon, and many uncertainties will only be resolved over decades, resulting in a long

timeframe until the option expires. Climate change uncertainties have been shown to be signifi cant, as is the

volatility of the new carbon markets. Some climate change options are company specifi c in that they relate to

changes in processes and energy use unique to each individual company. Other climate change options, however,

have a fi rst mover competitive advantage aspect in that they depend on the ability of a company to cease an oppor-

tunity and protect or extend this advantage over time. Real options valuation lends itself to applications where

volatilities of uncertain future outcomes can be quantifi ed. The international policy response to climate change

emphasizes the use of market mechanisms, which will lead to easier quantifi cation of climate change impacts

through revealed prices and costs of both mitigation and adaptation. Thus, the existence of carbon markets and

trading data facilitates the application of a real options analytical framework.

Combining the values of all climate change related real options embedded in a company’s assets in a portfolio

of options could theoretically provide a measure of the impact of climate change on a company’s shareholder value

today. However, due to the complexity of the actual real options valuation processes, and their signifi cant departure

from the most commonly used discounted cash fl ow framework, this may be a less practical approach until these

tools are better understood, accepted and refi ned. Whilst the quantifi cation of real options is analytically robust,

authors on the topic emphasize that real options are best understood as a way of thinking. As such, from a

managerial decision-making perspective, using real options requires ‘. . . appreciating what types of options exist,

how they can be created, how and why option values change, and how to capture their value’ (Mauboussin, 1999,

p. 8). The more important result of real options valuation lies in its thinking and strategic approach. Consequently,

the ‘. . . journey is more important than the destination’ (Mauboussin, 1999, p. 13).

Options thinking has been applied extensively to climate change issues from an economic and policy perspective

in order to inform international policy development in response to the many uncertainties surrounding the science



of climate change (WWF, 1997; Toman, 1998; Heal and Kristom, 2002; IEA, 2006). Climate change has also been

incorporated into real options analysis for energy sector investments (IEA, 2006; Majmin, unpublished Ph.D.

research proposal). However, there appears to be a dearth in research demonstrating the potential application of

real options in conceptualizing and quantifying the impact of climate change on company value. Therefore, the

purpose of this paper is to explore the application of real options in the context of capital budgeting decisions

involving a project that arises from climate change mitigation policy.

Research Design

This research employed an exploratory case study approach (Cooper and Slagmulder, 2004) in gathering data for

the following reasons. Due to the emerging nature of this fi eld and the dearth of prior research, it is diffi cult to

achieve deduction due to the lack of existing principles of a paradigm, the lack of established principles and con-

structs, and/or inadequate accepted principles and constructs (Perry, 1998). Case study research areas are usually

contemporary (Yin, 1989; Perry, 1998), and therefore an exploratory case study approach is regarded as a more

appropriate research design, given lack of previous studies (Yin, 1989, 1994; Cooper and Slagmulder, 2004). Also,

the case study research enables the [gathering and understanding] of intimate, contextually sensitive knowledge

of actual management practices (Keating, 1995).

Research Setting

The case is based on a clean energy project being undertaken by Sappi Ltd, a vertically integrated pulp and paper

global company headquartered in South Africa. South Africa is classifi ed as a developing country under the Kyoto

Protocol, and as such does not currently have emission reduction targets. However, as one of the top 20 highest

greenhouse gas emitting countries, it is facing pressure to take on some form of commitment after the fi rst phase

of the Kyoto Protocol ends in 2012. Whatever the form of the commitment, it is likely to penalize ineffi cient energy

use, or the use of fossil fuel generated energy, in some manner. Currently, greenhouse gas emissions arising from

energy use in South Africa are unregulated, although South African companies can generate emission reduction

credits from Clean Development Mechanism (CDM) projects under the Kyoto Protocol. The exploration of the

application of real options analysis to climate change impacts was done though the valuation of the company’s

option to make use of this mechanism. The pulp and paper sector is a high consumer of energy in the milling

process. It also generates a lot of waste biomass, which is used for power production. Amongst a number of other

climate change related risks and opportunities in the sector is the potential for greater use of biomass as an alter-

native to fossil fuel generated energy. In response to the opportunities that CDM presents, and the threat of future

carbon emission regulations, Sappi South Africa registered a CDM project for a fuel switching application at their

Tugela pulp and paper mill (hereinafter referred to as the Tugela CDM project), in South Africa (DNA, 2007). The

Tugela CDM project involves the conversion of a pure coal boiler to a co-fi red thermal boiler that burns a mix of

coal and bark. The boiler will generate 227 000 tonnes of steam energy per annum, using a combination of 70

000 tonnes of biomass and 3800 tonnes of coal. Through the CDM it also generates 55 912 tonnes of emission

allowances, termed Certifi ed Emission Reductions (CERs), per year, by replacing fossil fuel energy with biomass

energy over a ten year project crediting lifetime.

Under a conventional DCF analysis, the value of the Tugela CDM project to Sappi is ZAR31.9 million, and it

has a payback period of 2.7 years.3 Sappi’s investment decision hurdle rate is generally that of a payback period of

three years or less. However, in April 2006 the company’s management instilled a capital freeze owing to a run

of poor performance (Sappi, 2006), and maximum one year payback for all projects not prescribed by regulation.

Under this investment decision hurdle rate, the Tugela CDM project would not be allocated capital. The DCF

analysis may not, however, have captured the full value of the Tugela CDM project to Sappi.

3 The analysis was independently undertaken as part of the case study research, based on Sappi’s data.



Suitability of Real Options to the Tugela Mill CDM Project

There are a number of circumstances that would render this project more valuable to the company. Restricting

the discussion to the sub-set of climate change related circumstances in the Tugela CDM cash fl ows, the following

are identifi ed.

– The value of the CERs, and future of the CDM, is uncertain.4

– Carbon emission regulations may become a reality for South Africa in the future, exposing Sappi to increased

grid energy costs and an increased cost of biomass waste disposal (both landfi ll costs and transport costs). Both

of these will increase the opportunity cost to Sappi of not undertaking the Tugela CDM project.

– A system of Tradable Renewable Energy Certifi cates (TRECs) is being considered in South Africa. Should this

become a reality, the Tugela CDM project may be able to secure an additional revenue stream with insignifi cant

additional costs.

– The combination of climate change impacts on Sappi’s milling and forestry operations may render paper pro-

duction unfeasible in an economic system that prices in carbon emissions. The Tugela CDM project represents

a possible strategic move into renewable energy generation as an alternative business opportunity.

– The pulp and paper industry has a largely negative reputation with regard to environmental issues. As climate

change becomes more highly profi led, the company’s social licence to operate may be further eroded. Increas-

ing the renewable energy component of its power usage and accessing the CDM may enhance its reputation in

this area and offer a new marketing focus for Sappi.

– Sappi has a portfolio of nine further potential CDM projects using biomass to replace conventional fossil

fuel generated electricity, representing an annual carbon revenue stream of $3.8 million. Successfully register-

ing the Tugela CDM project may convince management to allocate capital to develop the remaining nine

projects.

Real options analysis can quantify the option value of management fl exibility to respond to the evolution of the

uncertain aspects identifi ed above. Whilst it is possible to consider the entire set of uncertainties using real options

analysis, only one source of uncertainty will be considered for the purpose of illustration: that relating to the CER

revenue stream. This is a conservative approach, undertaken in order to keep the analysis clear and transparent,

and to demonstrate the workings and value of the real options technique. Considering the full set of uncertainties

outlined above would theoretically increase the option value.

Carbon credits are denominated in dollars or euros, rendering them particularly attractive revenue streams

should the Rand exchange rate depreciate. By owning the right to undertake this project at the Tugela mill anytime

before 2012, Sappi owns an option to delay implementing the project until such a time that circumstances are more

favourable. By not being forced to implement the project now, Sappi does not expose itself to the downside risk

inherent in the uncertainty surrounding the carbon prices determining the project’s value. Should the company

divest the mill, it would lose this particular option to generate carbon credits through the use of biomass.

The value of management fl exibility relating to the CER revenue stream is assessed, added to the DCF value for

the project, and then compared with Sappi’s current hurdle rate.

Mechanics of the Real Options Approach in the Tugela Mill CDM Project

A conventional DCF analysis of the Tugela CDM project reveals an NPV of ZAR31.9m. Key inputs and assump-

tions used by this research to undertake the analysis are described in Table 1.

Using a real options perspective, the value of the project to Sappi today consists of not only the ZAR31.9 million

NPV calculated from the DCF, but also the NPV of the option to delay the project. This second part of the analysis,

referring only to the CER component of the option value, will be described using a binomial lattice approach,

selected for its mathematical simplicity, transparency and intuitive nature. The latter two properties of the approach

were held to be particularly appropriate, given the objective of the case study to explore and illustrate the

4 This is unclear given that the CDM is a mechanism of the Kyoto Protocol, which currently has no mandate to continue post-2012. However, international negotiations on this are ongoing.



application of real options as a tool to value climate change impacts. An example of a simplifi ed lattice model is

shown in Figure 1, to illustrate the underlying mechanics of the lattice approach.

Two lattices need to be calculated to solve an option value. Both types are demonstrated using the model in

Figure 1 above. In the fi rst lattice, the NPV of the underlying asset is represented at T0. This value has been dis-

counted at the company’s adjusted weighted average cost of capital (WACC) or a similarly appropriate rate. Each

subsequent node represents a point in time. The size of the time-step in years or months is determined by the

analyst up-front as δt. The lattice progresses in a step-wise manner to T1, using a probability factor to arrive at two

potential payoff nodes, one good and one bad. This process continues for the expected life of the option.

The second lattice is calculated from the fi rst, using a technique known as backward induction. Each node in

this second lattice represents the value maximization of either investing at that point, or waiting until the next

time period. The end nodes as represented by T2 in Figure 1 are fi rst considered. The fi rst lattice value of each end

node, less the cost of exercising the option, is compared with a decision rule for exercising the option. This deci-

sion rule is most often related to the company’s investment hurdle rate. For example, if the asset value at that

point less the cost is greater than the company WACC, the investment would be made. If the value of the under-

lying asset less the cost of exercising the option is greater than the decision rule, the net asset value is retained at

this node. If the value is less than the decision rule, the option will expire worthless at this point.

The next step is to calculate the values at the intermediate nodes (represented by T1 in Figure 1). These values

are the weighted average of potential future option values, discounted at the risk free rate, and using the risk-neutral

probability. The binomial lattice is completed back to T0, which gives the value of the option. Note that these lat-

tices do not represent actual decisions to be made in the future by management, but rather, are a mathematical

calculation to derive the value of the option, based on knowledge available today.

The following parameters were used to describe the two lattices in the case of Sappi’s Tugela Mill CDM

project.

1. The retrofi t will cost the company ZAR27m in capital costs, and R336 000 per year in additional operating costs.2. The cost of developing and registering the CDM project is conservatively estimated to be ZAR1 million (UNDP, 2006).

Ongoing costs of validating and issuing the carbon credits are anticipated to be in the region of ZAR328 000 per year (UNDP, 2006).

3. It is assumed that the project is implemented in 2007. A current CER price of US$10 is assumed up until the end of the Kyoto First Commitment Period in 2012 (Ambrosi and Kapoor, 2006). In the DCF analysis CERs generated post 2012 are assumed to be subject to a discounted price of US$2 given policy uncertainty after this point.7

Table 1. Tugela CDM DCF: Assumptions

Figure 1. The binomial lattice model. (Source: Mauboussin, 1999, p. 6)

7 This assumption is based on an 80% discount rate, suggested by some purchasers in the market at the time of writing.



Time StepsA time step of one year for each node was chosen, consistent with annual crediting of emission reductions from

the project: δt = 1.

Option TimeframeThe time period for which the option is valid is assumed to be fi ve years from the beginning of 2007, after which

it expires and has no further value. This period has been chosen given the Kyoto policy uncertainty post 2012, and

it has been assumed that no new CDM projects will be able to register after this point. Other factors that support

the choice of fi ve years option lifetime are issues of technological maturation and best practice additionality under

the CDM. Therefore, after 2012 it is assumed that Sappi will no longer be able to implement the CDM project

and the option expires worthless. The option to delay is defi ned as an American call option, as it can be exercised

at any point between 2007 and the option expiry date of 2012.

UncertaintyOnly the uncertainty and volatility inherent in CER prices were considered in the analysis. Other sources of uncer-

tainty in the project such as the cost of fossil fuels or the CER transaction costs were ignored for reasons of trans-

parency and simplicity. Therefore, the NPV of the CER revenue stream was modelled as the underlying asset, as

opposed to the NPV of the CDM project. This simplifi cation was not held to compromise the results of the research

because the inclusion of additional uncertainties would only serve to increase the option value and strengthen the conclusions.

Volatility EstimateThe volatility or uncertainty of the price of CERs has been calculated based on historical data, and is represented

by sigma; σ = 56.5%. Whilst using forward looking prices might have been more appropriate, futures prices for

the carbon market are not yet available, and forecasts give wide-ranging and incomparable prices due to the dif-

ference in the assumptions upon which they are based. EU ETS price data from 11 February 2005 to 6 September

2006 sourced from Reuters comprised the underlying data. EU ETS prices are used in lieu of CER prices for a

number of reasons. First, the price of CERs is subject to very low transparency in that it is contract and project

specifi c, and seldom disclosed. Second, whilst there is currently a spread between CER and EU ETS prices, Emis-

sion Reduction Purchase Agreements increasingly link CER prices to the EU Emission Trading Scheme price,

suggesting that the volatility of the two units is comparable. Third, once a CER has been issued, subject to an

outstanding technicality presented by the requirements of the International Transaction Log (Kyoto Protocol, 1997),

it is theoretically fully fungible with an EU ETS unit.

The number of historical data observations required for estimating volatility, according to conventional rule of

thumb, is the number of days to which the volatility will be applied. In this case, fi ve years worth of trading days

(252 days per annum) gives 1260 observations. Unfortunately, data is only available for 395 observations given

that the EU ETS only began in 2005. This is recognized as a potential limitation of this analysis. Time is measured

in trading days as opposed to calendar days, as this has been found to be the appropriate measurement for volatil-

ity calculations (Hull, 2003). A data smoothing technique has been used to account for a break in the data in April

2006. The average volatility is taken from the set of one month annualized volatility estimates, to arrive at σ =

56.5%. The volatility of the un-smoothed data set is signifi cantly higher, at 75.7%, suggesting that the average

volatility fi gure used may be conservative at this early stage of market maturation.

Up and Down FactorsThe up and down steps in the lattice represent the risk neutral probabilities, determined by the volatility (σ),

impacting on the asset’s value. They are required to calculate the lattice of the projected CER revenue for the

following fi ve years, and are described by the following equations:

up step: eu t= σ δ (1)



down step:e

dt

= 1σ δ

(2)

Based on the calculations done using the data for the Sappi CDM project, the up step value is 1.76 and the down

step is 0.57.

The Risk Free Raterf = 8.5%. Sappi uses a 10 year yield curve on debt; the R201’s current yield5 is used as their risk free rate (Hawkes,

personal communication).

Probability FactorThe probability factor is described by the following equation:

pt t

t t= −

−

−

−

e e

e e

rfδ σ δ

σ δ σ δ

Using this probability equation, the probability factor calculated is 0.44.

Decision RuleSappi will exercise the option, or implement the CDM project, when the project is paid back within a year. Assum-

ing all other variables are constant, and returning to the DCF analysis, this will occur when the NPV of the CER

revenue stream is ZAR158.8 million. Therefore, when the value of the CER revenue stream is greater than or equal

to this amount, it is assumed that Sappi will decide to implement the CDM project.

Cost of Exercising the OptionThe cost of exercising the option is the cost of developing the Tugela CDM project. This amounts to ZAR28.04

million, comprising the capital expenditure plus the upfront CDM costs. The NPV of the CER revenue stream in

Year 0, calculated as part of the DCF analysis, is ZAR20.1 million. Multiplying this by the up and down factors

results in the two nodes at Year 1, and so on until the lattice is fully described by Year 5.

Results and Interpretation of Real Options Valuation

This section presents the results of the application of the Real Options approach to the Tugela CDM project, and

solves for the value of Sappi’s option to delay developing the Tugela CDM project.

To solve the value of the option, we fi rst present the binomial lattice of the underlying asset (the CER revenue

stream) calculated using the inputs described in the preceding section. Second, we then derive and present the

option valuation lattice from the binomial lattice. Figure 2 presents the binomial lattice of the underlying value of

the Tugela CDM project.

At t0, the NPV of the CER revenue stream is ZAR20.1 million, the same as that used in the DCF analysis. In a

year’s time (t2), this value may have increased to ZAR35.4 million if carbon market conditions are favourable, or

decreased to ZAR11.4 million if markets are unfavourable. In a similar fashion, the potential NPVs in each year

of the option’s life are determined, based on the volatility of the carbon market, and the company’s risk free rate.

The range of values increases the longer the life of the option.

From Figure 2, we derived the second lattice, as presented in Figure 3, as follows. First, the end nodes of the

lattice in Figure 2 (the potential NPV of the CER revenue stream in Year 5) less the cost of exercising the option

(developing the CDM project, ZAR28.04 million) are compared with the ZAR158.8 million decision parameter.

5 www.fi n24.co.za [20 September 2006].



0 1 2 3 4 5

339,028,416

192,690,240

109,517,453 354,715,901

62,245,356 653,542,26

35,377,780 087,773,53 087,773,53

20,107,320 023,701,02 023,701,02

11,428,199 991,824,11 991,824,11

6,495,333 333,594,6

3,691,688 886,196,3

2,098,209

1,192,538

Year

Figure 2. Binomial lattice of the CER revenue to the project over fi ve years in rands

0 1 2 3 4 5

310,988,416

124,792,016

50,075,972 0

20,094,258 0

8,063,332 00

3,235,617 00

000

00

00

0

0

Year

Figure 3. Option valuation lattice



The results show that only the top right hand node compares favourably. Sappi would therefore theoretically decide

to exercise the option at this point by developing the CDM project, and realize the value of ZAR339m – ZAR28.04m

= ZAR310.9m as depicted in Figure 3. The decision at the other four end nodes would be to let the option expire

unexercised, and therefore worthless. Note that there is no downside risk to holding the option until this point.

Second, the intermediate nodes are derived using the backward induction technique, and risk-free probability

analysis. Recalling that the values at these nodes are the weighted average of potential future option values,

discounted at the risk free rate, and using the risk-neutral probability, they are defi ned by

intermediate value e e e rf= ( ) + −( )⎡⎣ ⎤⎦− − ( )p pt t tσ δ σ δ δ1 (3)

The value at the intermediate nodes indicates the remaining value in the option at that point in time, in this case,

the value of the option to delay the implementation of the Tugela CDM project. The option value lattice, whose

results are presented in Figure 3, is completed when Equation (3) is applied to the intermediate nodes, solving for

the option value in Year 0. This lattice therefore solves for the option value, with the results showing that the

option to delay the Tugela CDM project is worth ZAR3.2 million to Sappi in NPV terms. Recall that this analysis

has only considered one source of uncertainty as driving the value of this option. Were all sources to be considered,

it is anticipated that the option value would have been signifi cantly higher.

The way to interpret the ZAR3.2m is that there is additional value embedded in the Tugela mill and Sappi’s

managerial ability to design and implement a CDM project. In this case the option value is low relative both to

that of the conventional DCF analysis, and to the upfront cost of exercising the option of R28 million. The primary

reason for the low value of the option in this case is that the valuation holds constant all sources of uncertainty

apart from the CER price. By incorporating the additional volatilities and uncertainty related to future fossil fuel

prices, demand for renewable energy, costs of waste disposal, and strategic and reputational considerations for

Sappi, the option value would theoretically be anticipated to increase. This is fairly straightforward to value by

using Monte Carlo simulation to assess the NPV of a DCF analysis, and incorporating the sum of the additional

volatilities. The underlying asset would then be the CDM project value as an entity as opposed to the CER revenue

stream. Alternatively, one could value each source of uncertainty independently and sum the value implications

to arrive at the total option value.

A second reason for the low value is that the carbon revenue generated by this project represents a small portion

of the overall returns to the project, and therefore is not a primary driver of the project’s value. This will not nec-

essarily be the case for other CDM projects. Given the CDM’s additionality requirement,6 theoretically the CER

value should drive the project’s value. This has interesting implications for a company’s prioritization of CDM

projects, and also for the methods used to argue and prove additionality, which are beyond the scope of this

paper.

In some cases, the option value may dwarf the value obtained in the DCF analysis. If the option analysis is not

undertaken, the company is at risk of losing or not realizing potential value embedded in assets or projects in

option format. Real options related to climate change, because of their high uncertainty and strategic characteris-

tics, have a strong likelihood of being sources of signifi cant future value.

Climate change impacts other than the CDM are also likely to yield high option values for Sappi. For example,

while the CDM option expires in 2012, the uncertainty regarding some of the physical impacts such as increased

risk from pests and fi re to Sappi’s plantations may only be resolved decades hence. Similar long timeframes are

likely to exist with regard to regulatory risk resolution. In addition, the risk of extreme weather events is arguably

higher than that of the carbon prices used in the Tugela CDM project analysis above, as a once-off irregular heat

wave could severely damage Sappi’s plantations, with potentially signifi cant negative consequences on the compa-

ny’s downstream operations. Options to switch, scope up or delay as a result of both climate change regulatory

and physical risk abound in both the plantation and milling operations of the company.

6 One of the requirements of the CDM is that the project results in emission reductions additional to those that would have occurred in the absence of the certifi ed project activity (Kyoto Protocol, 2007). One implication of this text is that projects that are profi table without the CDM should not be eligible.



Research Implications and Contributions

Real options analysis of Sappi’s Tugela Mill CDM has demonstrated a source of value in the form of options that

are overlooked by DCF and other traditional fi nancial valuation measures. Because only one uncertainty driver has

been considered in this analysis, the option value is low and relatively insignifi cant. However, taken together, an

argument has been made as to why climate change related options are likely to be high and signifi cant. The exis-

tence and value of these options may have important implications for the strategic planning and capital budgeting

processes within a company such as Sappi. For example, should Sappi need to dispose of one of two similar mills,

knowing that the fi rst has a valuable climate change related option embedded in it may inform the decision in

favour of disposing of the second. Faced with installing two different types of technology, Sappi may choose to

invest in the one that is more expensive in that it creates a valuable option related to potential climate change

regulation in the future. Therefore, the understanding of the options relating to the impact of climate change on

the company does provide Sappi’s management with insight regarding the relative value, positive or negative,

embedded in various projects and assets. This insight would be useful in prioritizing the implementation of

different projects, and in ensuring that those with particularly high options values yet low DCF values are not

discarded. Without conducting a real options valuation, a potentially signifi cant source of value would be

overlooked.

A real options approach can similarly help a company identify areas where they can create valuable options to

hedge against climate change uncertainty. The greater the number and value of these options, the better the

company is positioned to grasp opportunities and mitigate the losses that climate change presents. Understanding

the climate change related options of a company provides additional information to analysts wishing to assess the

future fortunes of the company, particularly with regard to climate change. A company with a greater number of

more valuable options has better chances of surviving the transition to a low carbon economy than one with fewer,

less valuable options.

However, real options analysis has its potential limitations due to a number of factors. The methodology and

mathematical rigor supporting real options analysis is still maturing and remains fairly complex and involving.

This reduces its appeal to practitioners, particularly if climate change is not given high priority by management.

Whilst the application of real options analysis to climate change opportunities is intuitively fairly easy to grasp,

the accurate framing and valuation of negative real options is more complex, and will require further work to

confi rm its application. In addition, the data required for real options analysis is equal to, if not greater than, that

required for DCF, which presents further challenges in the valuation of climate change impacts. Real options

valuation also requires accurate volatility estimates in order to produce more accurate results. However, while

suffi cient historical data is not currently available for a satisfactorily robust analysis, the trend towards market

mechanisms to regulate greenhouse gas emissions increases the likelihood of data availability in future. This will

enhance the accuracy of the scientifi c estimation of the likely impacts from climate change.

The analysis in this paper could have benefi ted from a more sophisticated approach to modelling uncertainty.

In research considering the use of real options in the power generating sector (IEA, 2006), the once-off uncertainty

of the post 2012 policy regime was treated as a price shock, a discrete jump in price at some known time in the

future. This is as opposed to the random walk approach of this paper, which assumed that uncertainty around the

CER price post 2012 was incorporated into the CER price volatility factor. Including this modelling technique

would have increased the sophistication of the real option analysis, and improved the robustness of the results.

The random walk approach was used in order to keep the valuation simple and transparent.

Despite these limitations, this research has shown that real options analysis had the potential to enhance the

understanding of the impact of climate change on the value of a project. Using a process of analytical generaliza-

tion, it is suggested that the real options approach could similarly enhance the understanding of climate change

impacts on other projects, and on company value in general, and further research is encouraged to test this.

Further, the results of this study suggest that a real options approach may be especially appropriate for companies

with operations in non-Kyoto Annex B countries, given the additional climate change regulatory uncertainty that

they face. The approach may also be particularly applicable to sectors such as pulp and paper, which have highly

volatile value drivers and therefore greater uncertainty around future cash fl ows even in the absence of climate



change. Therefore, this research contributes to fi nance theory by demonstrating the potential usefulness of real

options in the face of uncertainties and strategic considerations brought about by climate change impacts. By

providing an approach that enables management to understand and calculate embedded value in capital projects

that involve high levels of uncertainties, this research contributes to the narrowing of the gap between fi nance

theory (with its focus on DCF approaches) and practice (which is increasingly being dominated by the socio-eco-

nomic impacts of climate change).

Conclusion

The real options valuation technique has been found to enhance the understanding of climate change impacts on

company value by identifying and quantifying a source of value to Sappi resulting from a CDM project that had

not been captured by the traditional DCF approach. Whilst in this case the additional value is not found to be

signifi cant, the analysis has demonstrated why climate change related options are likely to hold substantial value

for Sappi’s remaining CDM projects, and other assets of the company. This value is overlooked by DCF analysis

and other mainstream valuation techniques. This fi nding points to a number of areas for further research, both

to confi rm and extrapolate the use of real options to enhance the understanding of climate change impacts on

value.

• Real option analysis may provide insights into the impact of climate change on projects and companies in

general, and particularly those operating in Kyoto’s non-Annex B countries, where climate change policy is

subject to additional uncertainties.

• Considering the application of real options valuation to the CDM specifi cally may assist in understanding the

relative value of various CDM projects in a portfolio, and provide insight to project developers regarding

the timing of the sale of their CERs. It may also help project developers to gauge whether to proceed with the

development of a new CDM or to wait until an applicable methodology has been registered by another party.

• This research suggests that the greater the number of valuable real options a company owns and identifi es, the

better its position to adapt to climate change and a carbon constrained future.

Acknowledgements

With acknowledgements and thanks to L. Majmin and K.Naude for corrections to the formulae used in this paper.

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Documents

The use of real options valuation methodology in enhancing the understanding of the impact of climate change on companies