Technology-driven Investment in Aluminum Smelters: Real Options Valuation Under Uncertainty
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Aluminum producers are considering investments in aluminum smelter capacity as a response to an expected aluminum supply deficit due to ongoing production cuts in China and a strong development in demand. These investments are characterized by a high upfront cost and a high degree of irreversibility, and thus require a thorough evaluation of the project before the investment can be undertaken. Furthermore, the investment in an aluminum smelter is subject to multiple sources of uncertainty that must be accounted for. We apply the real options approach to examine the investment opportunity of an aluminum producer that has the option to invest in aluminum smelter capacity. First, we develop a single-factor model with the goal of maintaining analytic tractability and isolating the impact of technological uncertainty. Herein, we obtain an expression for the critical energy intensity threshold where it becomes optimal to invest. We find that the option value increases as the energy intensity gets lower, converging towards the net present value of investing as we approach the critical threshold. Furthermore, we find that the value of waiting is largest at the moment the net present value becomes positive, and that both an increased frequency of innovations and increased decrement of energy intensity per jump increases the option value. We then extend the initial model to a multi-factor model that in addition to technological uncertainty incorporates uncertainty in aluminum price, electricity price and foreign exchange rate. In order to find the optimal investment strategy for the multi-factor model, we develop a numerical algorithm based on the least-squares Monte Carlo method. We apply the models to an aluminum smelter case study and compare the single-factor and multi-factor results. We find find that the additional uncertainty introduces a value of waiting that was not present in the single-factor model. While it is optimal to undertake the investment 100\% of the time according to the single-factor model, the multi-factor model indicates that the probability of investing is approximately 77\% for current levels of energy intensity. We find that the aluminum price uncertainty is the most important source of uncertainty for the investment decision. Our findings indicate that being able to increase the innovation frequency through additional investments can be highly valuable, even for our medium-sized case study smelter. Lastly, the model can be adapted and used to appraise research and development efforts for a wide range of industries that are subject to technological uncertainty.