Valuing flexibility: The case of an Integrated Gasification Combined Cycle power plant

In this paper we analyze the choice between two technologies for producing electricity. In particular, the firm has to decide whether and when to invest either in a Natural Gas Combined Cycle (NGCC) power plant or in an Integrated Gasification Combined Cycle (IGCC) power plant, which may burn either coal or natural gas. Instead of assuming that fuel prices follow standard geometric Brownian motions' here they are assumed to show mean reversion, specifically to follow an inhomogeneous geometric Brownian motion. First we consider the opportunity to invest in a NGCC power plant. We derive the optimal investment rule as a function of natural gas price and the remaining life of the right to invest. In addition, the analytical solution for a perpetual option to invest is obtained. Then we turn to the IGCC power plant. We analyse the valuation of an operating plant when there are switching costs between modes of operation, and the choice of the best operation mode. This serves as an input to evaluate the option to invest in this plant. Finally we derive the value of an opportunity to invest either in a NGCC or IGCC power plant, i.e. to choose between an inflexible and a flexible technology, respectively. Depending on the opportunity's time to maturity, we derive the pairs of coal and gas prices for which it is optimal to invest in NGCC, in IGCC, or simply not to invest. Numerical computations involve the use of one- and two-dimensional binomial lattices that support a mean-reverting process for coal and gas prices. Basic parameter values are taken from an actual IGCC power plant currently in operation. sensitivity of some results with respect to the underlying stochastic process for fuel price is also checked. (C) 2006 Elsevier B.V. All rights reserved.