An Investment Decision under the Clean Development Mechanism: A Real Options Approach

Abstract

One of the main challenges that investors in the Clean Development Mechanism (CDM) project face is the management of the volatility of the price of Certified Emission Reduction (CERs). Large scale CDM projects require a long-term investment with significant amount of costs, and this type of investment is often irreversible. Project investors should quantitatively assess the CER trigger price that justifies the initiation of a CDM investment. The traditional discounted cash flow valuation is unable to capture the option value associated with uncertain investment, and thus it tends to underestimate the trigger price which initiates the investment.

Real options theory explicitly considers the option value of delayed investment and can provide a better measurement of the trigger price. This paper presents a theoretical model of the CDM investment project and derives the CER trigger prices that guide investment decisions by using historical market data. It develops a stochastic dynamic programming model for both the geometric Brownian motion process and the mean-reverting process. An analytical solution for the trigger price is derived for the former process, and the trigger price is numerically estimated for the latter. By considering various parameter values, it analyzes the effects of different market environments on the trigger price.