Real Options Volatility Surface for Valuing Renewable Energy Projects

Abstract

Real options analysis is an adequate tool with which to value companies and projects under investment uncertainty. Nevertheless, the estimation of the volatility to be employed in the valuation procedure is a challenging task. The volatility parameter not only affects the investment value, but is also important in strategic decision-making. The aim of this paper is to provide a suitable methodology for the estimation of volatility in real option project valuation, with a focus on renewable energy projects. Our procedure is a straightforward extension of the implied volatility methodology employed for financial options; however, our proposal considers the debt-to-equity ratio instead of the moneyness or strike price. Thus, the volatility of the project is the implied volatility obtained from the volatility surface of comparable firms for a certain valuation date and the given debt-to-equity relation of a renewable project. Furthermore, the natural spline model is utilized to calibrate the volatility surface for real option valuation purposes. The empirical results demonstrate that the implied volatility ranges from 3.37% to 113.78%, with median values between 16.42% and 47.10%, in the period from January 2014 to December 2020, for our research study. Finally, we consider that our proposal is a natural and straightforward manner in which to estimate the implied volatility for projects under investment uncertainty, since real option valuation is based on the same idea and tools used in financial option pricing.