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Energy investment decisions under public policy uncertainty

Shahnazari, Mahdi (2015) Energy investment decisions under public policy uncertainty. PhD thesis, Murdoch University.

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Global energy demand will continue to increase over the coming decades driven by economic development and population growth. In terms of final energy use, electricity is the fastest growing source of energy [1] and the electrification of the world’s energy consumption mix is expected to increase significantly from 17% in 2010 to 30% in 2050 [2]. Over the period from 2012 to 2050, a 123-150% increase in electricity demand is forecast and a substantial level of investment in electricity generation is required to meet increasing demand in the coming decades. The corresponding investment capital required during the same period is estimated to be US$19 to US$26 trillion.

The electricity generation industry is a supporting pillar of economic development that has to meet social, economic and environmental goals in the regions it operates [3]. The transformation and development of the industry under such multi-dimensional goals, however, have proved to be an immense challenge. Creating a balance between energy security, equity and environmental objectives shapes the sustainability of the electricity supply system. Nonetheless, pursuing each of those objectives individually may result in a failure to achieve the others, ultimately leading to an energy trilemma. In many economies, the power generation sector has continually experienced a transition towards liberalized markets to promote economic efficiency via the introduction of competitive forces. In fact, in the sector, the efforts to meet the equity objective of the energy trilemma have commenced since the late 1980s to deliver low-cost energy to consumers and maximise social welfare. Following deregulation, a different allocation of responsibilities between government and private sectors has caused public spending in electricity generation to decline. Demand-driven price signals in wholesale and contract electricity markets drive private investments in power generation. Public policies, however, shape the mix of generation technology to ensure sustainability of the system via the achievement of environmental and security goals. Opening the sector to competition has resulted in the internalisation of investment risk in the decision-making process [4]. In addition to expected investment return, private investors make choices based upon the exposure of different generation technologies to various sources of financial and business uncertainty including, but not limited to, regulations, economic factors, input and output prices, and the volume of sales.

This thesis focuses on the effect of public policy uncertainty and relative interactions on large-scale electricity generation investments. From a diverse and extensive set of public policies affecting the sector, this study concentrates on energy and climate policy instruments aiming to achieve environmentally cleaner electrical energy while upholding the security of supply and economic efficiency. This choice is not arbitrary, noticing that the electricity generation sector, globally, is a major contributor to greenhouse gas emissions (25% of total anthropogenic greenhouse gas emissions [5]). The fifth assessment report by the Intergovernmental Panel on Climate Change [5] recognises that the power sector plays a crucial role in achieving mitigation targets. Although jurisdictions around the world have implemented policies to promote the mitigation of greenhouse gas emissions, such policies have been subject to significant changes, primarily due to the global disagreement over mechanisms to curb emissions. The frequent changes in the design and implementation of regulations are inhibiting efficient investments in the electricity generation sector.

This thesis develops a decision-making framework for investments in the electricity generation sector that accounts for the effect of energy and climate policy uncertainty and their interactions, while taking the perspective of a private investor. It aims to investigate how continuing energy policy uncertainty and correlations may affect the choice and timing of investments. As such, this thesis makes its contribution in three broad steps: (1) the development of an investment decision-making model for individual investments to evaluate the effect of significant policy changes, (2) a study of the effect of political cycles and the integration of subjective information as represented by experts’ views within the model developed in step (1), and, (3) a portfolio analysis to expand the modelling framework for use in long-term strategic planning in corporate energy entities where the specific characteristics of the electricity generation sector along with policy interactions are recognised. Although, the viewpoint adopted concerns private investments, the framework developed can provide insights to policy makers regarding the effect of political uncertainty and policy interactions on energy investment decisions and the desired mix of energy technologies.

This research employs a real options analysis method to develop the investment decision-making model in step (1) and (2). In contrast to the conventional investment decision-making approaches, such as the levelised cost and discounted cash flow methods used in the sector, real options methodology allows for the investigation of optimal investment timing and exercising managerial flexibilities under uncertainty. An American-style option valuation method is used for this purpose that employs a numerical dynamic programming method to solve the individual investment decisionmaking model. The real options method developed in the first two steps is integrated with a portfolio optimization framework in step (3) that views the power generation investment problem from a portfolio perspective. To demonstrate the application of the model, case studies are developed based on the relatively recent actual energy policy outcomes in Australian context. In particular, this thesis is very topical as the case studies focus on the recent changes in carbon pricing mechanism and renewable portfolio law in Australia, with further consideration over their correlation.

The results of the modelling suggest that political uncertainty after the implementation of carbon pricing is detrimental to the achievement of policy objectives. Investors may defer their investment in less carbon intensive technologies. However, this effect can be mitigated by implementing higher expected carbon prices. Although political uncertainty with respect to greenhouse gas (GHG) mitigation policy may delay investments in environmentally cleaner assets, expectations over the reinstatement of carbon pricing reduce the amount of option premium to defer those decisions. The results of modelling in step (3) show how a co-existing and relatively stable renewable portfolio standard mechanism may negate the effects of carbon pricing uncertainty.

Although an adequate flow of investment capital to the energy sector may be available [6] and various energy policies may exist to promote the sustainability of the energy mix, the findings of this research, however, suggest that uncertainty over the future of those policies and their resulting interactions may substantially erode the triple objectives of a sustainable energy system. The most effective remedy for this issue is commonly espoused by various stakeholders - eliminate uncertainty in policies. Nevertheless, global disagreements and opposing political agendas have proved that such an ideal solution does not exist. By modelling investor’s strategic behaviour and risk management practices, this research provides insight on the way that the impact of policy uncertainty on investment can be dampened in order to expedite the achievement of a sustainable energy system.

Publication Type: Thesis (PhD)
Murdoch Affiliation: School of Engineering and Information Technology
Supervisor: Whale, Jonathan
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