A Real Options Model for Sustainability Evaluation
In the Age of the Anthropocene, human activity is capable of leaving a clearly identifiable mark on the planet’s surface and permanently impact the functioning of the Earth System. Climate change caused by anthropogenic carbon emissions is one of these impacts, and the main activity responsible for these emissions is energy generation and consumption. Many countries have pledged to reduce carbon emissions, setting individual targets and implementing policies to incentivize investing in low-carbon energy and energy efficiency, among other actions. However, investing in energy efficiency is a wicked problem because of the conflict it creates between increasing costs and total energy savings. With traditional project valuation tools that focus mainly on minimization of costs or maximization of profits, energy reduction projects risk being rejected because of the high uncertainties involved, missing the potential contribution to the overarching sustainability targets. The reason is twofold. First, the focus on financial performance of traditional project valuation tools prevent the decision maker from seeing the impact on the relevant sustainability targets clearly due to the transformation of energy savings into cash savings tied to the current cost of energy. This implies the need to use a multi-dimensional sustainability indicator determined by the sustainability targets that the project aims to contribute to. Secondly, energy reduction projects are subject to high uncertainties, which traditional project valuation tools consider as an additional cost that reduces the project value. Real Options is presented as an alternative project valuation method that addresses these uncertainties directly through the contingent decisions of management, instead of dealing with them as costs. When used at the design stage of a project, Real Options can improve the expected value of a project, by mitigating the losses of the downside of risk while enhancing the benefits of the upside. This work is based on Design Science Research (DSR) methodology to develop and test a Real Options model for Sustainability Evaluation which is applied to the case of a rooftop photo-voltaic installation in the Civil Engineering building at the West Cambridge site. The sustainability problem is defined as the conflict between the two interdependent issues of generational distribution and physical limits of Earth. Under this definition, two opposing sustainability paradigms are reviewed, namely, Weak Sustainability (WS) and Strong Sustainability (SS). Given the purpose of this work, a Strong Sustainability paradigm is adopted as the foundation of the model, recognizing physical limits to human activity and the impossibility of substitution between nature and man-made capital. Indicators of sustainability relevant to energy projects were also reviewed and Energy Cost Metric (ECM) and Energy Surface Density (ESD) were selected as outputs for the model. The Real Option model consists of three main parts, (1) the overarching sustainability targets, (2) the energy project optimized design and (3) the real options analysis. To test the model, it is applied to the case of a rooftop photo-voltaic installation using Monte Carlo simulations. After the simulations, the model results suggest that it is likely to increase the project’s energy value after meeting a minimum economic performance by delaying the installation of the PV modules. |