Real options theory applied to the evaluation of small hydropower investments in Brazil

Abstract

There have been several challenges concerning the decisions and timing of new investments in the Brazilian power electricity generation due to irreversibility characteristics and uncertainty inherent in the sector, such as the volatility of electricity prices. Large hydropower plants are getting difficult to implement in the Brazilian generation sector, primarily due to environmental concerns and political pressure. Therefore, there has been an increasing focus on investments of small-scale hydropower plants (SHP). In this context, this paper analyses the use of Real Option (RO) theory for decision-making concerning the investment in SHP’s in Brazil. This paper investigates the possibility for the entrepreneur of postponing its participation in the auctions proposed by the government. The deferral option can bring relevant value to the evaluation of SHP since the investor has the option to wait until more favorable conditions appear, e.g., better electricity prices or authorization. Therefore, the application proposed in this paper may be considered as a novel approach regarding the application of the RO theory. For this purpose, a real SHP of 7 MW of installed capacity was used as an investment case and it was assumed that the entrepreneur has the option to participate in the auctions in the next three years (2018 - 2020). A comparison of the results considering the traditional economic analysis (based on the discounted cash flows) is undertaken to evaluate the proposed approach. It can be concluded that the deferral option in participating in the auction can be considered a real option for investors and this time flexibility might bring financial advantages since the uncertainties are reduced. Furthermore, the methodology proposed in this paper has great potential to assess future SHP project evaluation and can be adapted to evaluate other power options.