Multi-Commodity Real Options Analysis of Power Plant Investments: Discounting Endogenous Risk Structures

FCN Working Paper No. 22/2011

41 Pages Posted: 21 Jul 2012

See all articles by Wilko Rohlfs

Wilko Rohlfs

RWTH Aachen University - Faculty of Mechanical Engineering

Reinhard Madlener

RWTH Aachen University

Date Written: December 1, 2011


The value of power generation technologies can be derived from the investment cost, the plant’s expected lifetime, and the discounted cash-flows, the latter of which typically are a combination of several underlyings, such as the price of fuel, electricity, and CO2. To determine this value, most studies assume predefined, uniform, and constant discount rates, irrespective of the fact that the specific risk strongly varies with the technology concerned and also over time. In order to endogenize the technology-specific risk, we develop a new model that explicitly accounts for the (likewise technology-specific) combination of the underlyings. More specifically, we use a multivariate binomial tree real options approach for analyzing the value of different power plants (gas-fired and coal-fired, with and without carbon capture and storage (CCS); hydro; wind; photovoltaics) and for taking into account technical change. We further investigate the influence of alternative CO2 policies on the plants’ values, modeling the CO2 price in three different ways and for three different carbon price levels (5, 25, 45€/tCO2 ): (1) as a stochastic process (Geometric Brownian Motion), reflecting the price development in the Emissions Trading Scheme of the European Union (EU ETS); (2) as a (constrained) stochastic process with a price floor, and (3) as a deterministic carbon tax. From the model application, using data from German exchange-based markets and a much-cited pilot study on future energy strategies and scenarios in Germany, we find a strong preference for hard-coal power plants in the low CO2 price scenario (P2015 = €5) and a low value of waiting, irrespective of the CO2 price policy assumed. In the case of the moderate CO2 price scenario (P2015 = €25), the value of waiting is much higher for the CO2 permits with a price floor and the CO2 tax policy, leading to a dominance of the CCS power plants. In contrast, for the simulated EU ETS market, the conventional fossil fuel-fired power plants dominate the other technologies. In the high CO2 price scenario (P2015 = €45), the value of waiting only delays the investment decision in the case of the floored CO2 permit prices. For the two other policies, the model predicts an immediate investment in CCS power plants once the CCS technology becomes commercially available in 2020.

Keywords: Real options, CAPM, multivariate binomial tree, carbon tax, energy technology choice, endogenous discount rate

Suggested Citation

Rohlfs, Wilko and Madlener, Reinhard, Multi-Commodity Real Options Analysis of Power Plant Investments: Discounting Endogenous Risk Structures (December 1, 2011). FCN Working Paper No. 22/2011. Available at SSRN: or

Wilko Rohlfs (Contact Author)

RWTH Aachen University - Faculty of Mechanical Engineering ( email )

Eilfschornsteinstr. 18
Aachen, 52056

Reinhard Madlener

RWTH Aachen University ( email )

School of Business and Economics / E.ON ERC
Mathieustraße 10
Aachen, 52074
+49 241 80 49 820 (Phone)
+49 241 80 49 829 (Fax)


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