Real Options Conference 2022

Thursday, 23 June 2022
8:15am - 8:45am
8:45am - 9:00am
Session Chair: Lenos Trigeorgis
9:00am - 10:15am
Session Chair: Yuri Lawryshyn, University of Toronto
Workshop Highlights: A Real Options View On Infrastructure Investment
Dean Paxson, University of Manchester, United Kingdom
Public Infrastructure: Overview and Applications
Luiz Brandao, PUC-RIO and University of Texas at Austin, Brazil
Infrastructure projects typically involve large amounts of capital and significant risk, and governments worldwide have increasingly resorted to private investment to fund this class of projects. These agreements may include risk mitigating mechanisms which represent contingent liabilities for the host government, and since they have option-like characteristics, they require option-pricing methods to be valued and determined.
Public Infrastructure and Applications In N America and Eu Public Sectors
Yuri Lawryshyn, University of Toronto, Canada
10:45am - 12:00pm
Session Chair: Carlos Bastian-Pinto, PUC-Rio
Flexible-Term Government Concession Contracts
Carlos Bastian-Pinto, PUC-Rio, Brazil
Naielly Lopes Marques, PUC-Rio, Brazil
Luiz Bradão, PUC-Rio and U of Texas, Austin, Brazil
LPVR type of auctions have been regarded as the best solution to demand risk sharing between concessionaire and regulators in infrastructure concessions. Yet implementation has been infrequent, mostly because of the strong opposition by concessionaires who do not see an equitable compensation for demand risk asymmetry. We review and analyze of all the aspects of LPVR auctions and other similar approaches of Flexible Term Concession (FTC), and propose a Real Options model that considers LPVR principles but treats uncertainties and flexibilities in a more informative and applicable way.
Infrastructure Project Flexibility and Uk’s High-Speed Rail
Jacco Thijssen, University of York, United Kingdom
Stochastic Processes For Demand In Infrastructure Concession Projects
Naielly Marques, PUC-Rio, Brazil
Carlos Bastian-Pinto, PUC-Rio, Brazil
Luiz Brandão, PUC-Rio, Brazil
Determining the stochastic process to model inherent uncertainties (demand/traffic) in infrastructure concession projects may not be as simple a task as the literature on the subject suggests. Most papers in this area assume, without doing any statistical testing or further analysis, that demand or traffic follows a stochastic process known as Geometric Brownian Motion (GBM). In this article, we use unit root and variance ratio tests and the Parameter Approach Measure (PAM) to evaluate which would be the most appropriate stochastic process to model the uncertainties present in real cases of airport and road concessions. Our preliminary results show that, in the case of the analyzed airports, the Mean Reversion Process (MRP) is the one that presents the greatest suitability for modeling passenger demand, contrary to what has been assumed in the literature. We emphasize that this result is maintained even after correcting the demand series for the seasonality effect.
Session Chair: Benoit Chevalier-Roignant, Emlyon
Hao Bai, University of Manchester, United Kingdom
Alain Bensoussan, University of Texas at Dallas, United States
Gordon Briest, University of Magdeburg, Germany
Benoit Chevalier-Roignant, emlyon, France
Discussant: Shantanu Banerjee, Lancaster University
Many municipalities or governments face challenges in financing their infrastructure. Hong Kong’s transit operator designed a novel scheme whereby it receives fare revenues, but also partakes in a property management business, exploiting the positive externalities of public transport on property prices. We develop a Stackelberg game of timing under uncertainty to explore the rationale of this scheme. The underlying mathematical problem is nontrivial because the Stackelberg’s leader faces a two-dimensional optimal stopping problem (which cannot be reduced by a change of numeraire) with a gain function that is nondifferentiable due to strategic interactions. We solve this problem analytically via the intermediation of a ‘penalized problem’ and derive interesting, novel managerial insights. The main insight is that internalizing positive externalities provides additional revenue sources for defraying the overall costs of infrastructure investments, thereby accelerating the delivery of infrastructure.
Shantanu Banerjee, Lancaster University, United Kingdom
Swarnodeep Homroy, University of Groningen, Netherlands
Aureli Slechten, Lancaster University, United Kingdom
Discussant: Benoit Chevalier-Roignant, emlyon
This paper investigates the role of stakeholder preference on corporate social responsibility (CSR) strategies. Using a staggered difference-in-differences approach, we show that Indian firms increase CSR expenses when trade restrictions (Antidumping) are initiated against competing Chinese exports from countries with a high stakeholder preference for CSR. However, when these shocks emanate from countries with a lower stakeholder preference, CSR expenses remain unchanged. Capital expenditure and R&D of Indian firms increase following trade shocks, irrespective of their country of origin. Finally, CSR spending provides these Indian firms with significant real option value only when the demand shocks originate from countries with a higher CSR preference. Collectively, we provide evidence for consumer-driven CSR strategies.
12:00pm - 2:00pm
2:00pm - 3:15pm
Session Chair: Verena Hagspiel, NTNU
Feed-In Tariffs In Renewable Energy Projects
Luciana Barbosa, Instituto Universitário de Lisboa, Portugal
Cláudia Nunes, Universidade de Lisboa, Portugal
Artur Rodrigues, University of Minho, Portugal
Alberto Sardinha, Universidade de Lisboa, Portugal
This paper presents novel models for firms' valuation functions of fixed-price and fixed-premium, under market uncertainty. Our models allow the identification of the equilibrium bidding, the optimal time to deploy a renewable energy project, and the optimal time of the auction. We present several findings that are aimed at policy-making decisions.
Layered Collar Real Options Shared With A Third Party
Dean Paxson, U. of Manchester, United Kingdom
Roger Adkins, U. of Bradford, United Kingdom
We derive the optimal investment threshold and real option value for an investment opportunity, and separate values for each of the options, where there are layers specifying the proportions of the price that are shared with a third party. Findings are that the real option value of a layered collar is much lower than without a collar, and that lower thresholds are obtainable economically by reducing the layer levels, and increasing the floors, rather than providing a direct subsidy.
Energy Policy Uncertainty and Investment In Renewable Energy
Verena Hagspiel, NTNU, Norway
Session Chair: Mariia Kozlova, LUT University
Carlos Bastian-Pinto, IAG Business School, Pontifícia Universidade Católica of Rio de Janeiro, Brazil
Marco Antonio Haikal Leite, Instituto de Energia PUC - IEPUC, Brazil
Luiz Brandão, IAG Business School, Pontifícia Universidade Católica of Rio de Janeiro, Brazil
Florian Pradelle, Departamento de Engenharia Mecânica PUC Rio, France
Eloy Fernandes Y Fernandes, Instituto de Energia da PUC - IEPUC, Brazil
Naielly Lopes Marques, IAG Business School, Pontifícia Universidade Católica of Rio de Janeiro, Brazil
Discussant: Mariia Kozlova, LUT University
Renewable Energy Sources are intermittent in nature. Much more so is Photovoltaic energy, which depending on the project configuration and characteristics, is highly dependent on other sources or storage capacity. This situation makes that configuring a Photovoltaic Hybrid plant, is a matter of operational as well as economic optimization, depending on the situation, regulation and prices at a given moment. We argue in this paper that this optimal configuration can change over time, and that it is highly beneficial to design a plant with flexible complementary hybrid configuration. We use the real options approach to demonstrate this flexibility´s value and apply it to two hypothetical plants in Brazil: one for an agribusiness project in the state of Minas Gerais, and another for a hotel resort in the state of Bahia.
Mariia Kozlova, LUT University, Finland
Julian Scott Yeomans, Schulich School of Business, York University, Canada
Discussant: Carlos Bastian-Pinto, PUC-Rio
Corporate strategic decisions are often supported by evaluation with real options framework. However, the majority of real options studies choose to analyze generic types of real options. In this extended abstract, we demonstrate how customized real options can be systematically discovered by employing a recently developed approach called Simulation Decomposition or SimDec. SimDec is an enhancement of Monte Carlo simulation, which allows tracing how different input factors and their interactions affect the outcome(s) while preserving the holistic picture of the overall uncertainty. We show the application of SimDec to the two cases of corporate strategic decision-making: 1. Investment strategy and 2. Compliance with emissions regulations. Both cases demonstrate that SimDec reveals previously hidden interactions of factors in a model and provides actionable outcome by discovering optionality in strategic decisions.
3:45pm - 5:00pm
Session Chair: Hamed Ghoddusi, Stevens Institute of Technology
Hong Kong Transit Novel Infrastructure Financing: Exploiting Positive Externalities of Public Transport On Land Development Prices
Benoit Chevalier-Roignant, EMLYON Business School, France
Optimal Subsidies For Land Conservation: Discouraging Land Development
Elizabeth Whalley, University of Warwick, United Kingdom
Investment In Human Capital, Skilled Labor Migration and Brain Drain
Hamed Ghoddusi, Stevens Institute of Technology, United States
Session Chair: Semyon Fedorov, NTNU
Arkadiy Sakhartov, University of Illinois at Urbana-Champaign, United States
Toby Li, Texas A&M University, United States
Jeffrey Reuer, University of Colorado Boulder, United States
Ashton Hawk, University of Colorado Boulder, United States
Discussant: Lucas Mesz, Petrobras
Resource redeployment is the withdrawal of resources from their original use and allocation to another use. Such redeployment has been elaborated conceptually and studied empirically. While resource redeployment has been studied exclusively in multi-business firms, single-business firms can also redeploy resources. Moreover, empirical studies have measured resource redeployment only indirectly, thus casting doubt on the extent to which managers use it and on its antecedents. Therefore, this study theoretically examines resource redeployment in single-business firms, and then empirically demonstrates resource redeployment and its determinants. To elaborate resource redeployment theoretically, this study builds a formal model of resource redeployment in a single-business firm. The model derives that redeployment is positively affected by the inducement, which is the current performance advantage of the new use over the original use, and by uncertainty in that performance. Resource redeployment is also negatively affected by the redeployment cost. In addition, uncertainty negatively moderates the effect of the inducement. To test these predictions, this study uses a unique dataset covering oil wells drilled in Texas. The to-be-redeployed resource in this context is the rig that is possessed by a driller, which can withdraw the rig from one field and reallocate it to another field. Performance is captured by the revenue on drilling contracts in each field. The redeployment cost is operationalized based on the geographical distance over which the rig needs to be transported. The empirical tests robustly confirm the four theoretical predictions.
Semyon Fedorov, NTNU, Norway
Maria Lavrutich, NTNU, Norway
Verena Hagspiel, NTNU, Norway
Thomas Lerdahl, OKEA ASA, Norway
Discussant: Toby Li, Texas A&M University
The volatile environment of oil exploration and production sets new challenges to market players prompting them to explore new business models. In this paper, we analyze a novel type of partnering in oil and gas operations, i.e. the risk and benefit sharing schemes, that enable a field operator to bring third parties into the field development process. We develop a valuation method to assess the feasibility of the risk and benefit sharing schemes based on the real options approach and identify the optimal contract policy from the perspective of both the oil company and the contractor. We analyze two application cases where an oil company collaborates with a drilling contractor and a FPSO leasing company to share risks and benefits resulting from the oil field development. We incorporate an “exit” clause in the contract as an instrument to provide flexibility for the parties to withdraw from the partnership as uncertainty unfolds. Our results show that the risk and benefit sharing schemes with embedded flexibility have a potential to become an alternative form of contracting in oil and gas industry.
Lucas Mesz, Petrobras, Brazil
Marco Antonio Guimarães Dias, PUC-Rio, Brazil
Luiz Eduardo Teixeira Brandão, PUC-Rio, Brazil
Discussant: Semyon Fedorov, NTNU
This article models asymmetry in the war of attrition in oil exploration under uncertainty. The optimum moment for the players to invest depends on price uncertainty, the length of the exploration concession contract, the geological assets parameters, and the other company's competitive action. Geometric Brownian Motion is the assumed long-term oil price model, and the two players (oil companies) War of Attrition is the game for the competitive conflict. This paper expands Dias and Teixeira (2009), adding a more realistic scenario with an asymmetric case. The impact of strategic interactions is relevant, especially when the two firms have similar exploratory triggers. For the asymmetric games, the ratio between the exploratory and quit triggers defines the degeneration to drilling action of one of the operators. In order to perpetuate the conflict, the exploratory triggers need to be similar between the companies, even with different prospects and investment evaluations. This situation happens when the ratio between the premium and investment of the two companies' projects are similar. The upper price of the interval for perpetuating the conflict also needs to coincide in price, in effect a rare situation, since the quit trigger depends on the probability of finding hydrocarbons in the neighboring block.
5:00pm - 6:00pm
Session Chair: Dean Paxson, U. of Manchester, UK
6:00pm - 7:30pm
Saturday, 25 June 2022
9:00am - 10:15am
Session Chair: Linda Salahaldin, ESCE - OMNES
Rene Belderbos, KU Leuven, Belgium
Luca Del Viva, ESADE Business School, Spain
Lenos Trigeorgis, U. of Cyprus, Cyprus
Discussant: Linda Salahaldin, ESCE - OMNES
We argue that, compared with domestic M&As, cross-border M&As have positive performance implications for the acquirers in terms of an increase in growth option value when the acquisitions increase the diversity of the acquirers’ technology portfolio. This positive influence is strengthened if the target firms’ foreign country exhibits greater economic uncertainty. Exercise of embedded real options in diverse technology portfolios makes cross-border acquirers likely to experience higher profitability in the long term, while cross border M&As can be detrimental to short term profit. We find support for this real options logic of cross-border acquisitions in an analysis of M&As by the population of U.S. listed firms during 1991-2014.
Paulo J. Pereira, University of Porto, Portugal
Artur Rodrigues, University of Minho, Portugal
Discussant: Lenos Trigeorgis, U. of Cyprus
This paper studies the effects the overlapping ownership in acquisition deals. Different structures (controlling or non-controlling) for the common shareholder are considered. Furthermore, we analyze the acquisition dynamics both when the synergy only depends on controlling the target, as well as when full integration is required.
Linda Salahaldin, ESCE - OMNES, France
Salah Eddine El Ayoubi, Université Paris Saclay, France
Discussant: Paulo J. Pereira, University of Porto
This paper proposes a decision-making framework for entrepreneurs who are willing to launch their crowdfunding campaign on a crowdfunding platform. In particular, we propose a method, based on real options, for choosing the launch date of the campaign depending on the observed status of the platform. The entrepreneur's objective is to maximize the expected amount of funds she collects on the platform, and this latter depends on the quality of the proposed project, but also on the number and qualities of the concurrent projects during the campaign lifetime. We model the platform state evolution with time using a Markov chain and derive the expected campaign outcome starting from a given status. We then propose a dynamic programming approach that determines the optimal campaign launch time.
Session Chair: Florina Silaghi, Universitat Autònoma de Barcelona
Anne Balter, Tilburg University, Netherlands
Kuno Huisman, Tilburg University, Netherlands
Peter Kort, Tilburg University, Netherlands
Discussant: Florina Silaghi, Universitat Autònoma de Barcelona
Typically product demand follows a product lifecycle (PLC). This means that after a product is introduced, demand for this product first starts to grow, which after some time is followed by a decline in demand. Moreover, in most cases demand is stochastic. This paper combines these two characteristics by employing a geometric Brownian motion process with a first increasing and afterwards decreasing trend. Our aim of the paper is to investigate the optimal investment decision of a firm in production capacity. The investment decision involves deciding about the timing and the size of the investment. We make a distinction between firms being a ``product-lifecycle leader'' and a ``product-lifecycle follower''. For a PLC-leader the growth stage starts at the moment this firm invests. In case of a PLC-follower, the firm enters an existing product lifecycle, implying that the decline can already start before this firm even has invested. One of the interesting results is that a PLC-leader waits for a higher demand level before it invests with the same amount when the expected length of the growth interval is shorter. For the PLC-follower it holds that it may be optimal to invest earlier because of this probability that the decline could already start before the firm invests. In such a case the expected future demand is lower, which makes it optimal that the firm attracts less capacity. This makes the investment cheaper and then the firm does not need to wait for a high demand level to make the investment profitable.
Nicos Koussis, Frederick University Cyprus, Cyprus
Florina Silaghi, Universitat Autònoma de Barcelona, Spain
Discussant: Kuno Huisman, Tilburg University
We analyze a revenue sharing contract within a decentralized supply chain, extending prior works to a multiperiod setting under buyer production flexibility. We model a buyer’s capacity choice and utilization under external procurement, where quantities are obtained from a supplier firm. The supplier firm chooses a revenue sharing contract with the buyer by internalizing the impact this would have on buyer decisions relating to capacity, utilization choice and the final downstream price of the product. Our framework provides a valuation of the buyer and supplier firms under uncertainty and predictions on the optimal capacity choice of firms in downstream markets and the pricing policy of upstream firms in relation to buyer capacity constraints, the volatility and growth of downstream prices, and the elasticity of demand. We find that for a fixed revenue sharing contract a high volatility of downstream demand results in higher installed capacity by the buyer to account for future flexibility to adjust production which makes a given contract more valuable for both the buyer and supplier. We generally find however a higher revenue share claimed by the supplier when downstream demand is more volatile. In an extension of this framework we also show that suppliers could impose minimum order quantities to extract value from a buyer firm by limiting buyer’s production flexibility. We also consider the decisions of a vertically integrated firm showing that the gains from vertical integration are higher when volatility is high, that is, when production flexibility is more important.
10:45am - 12:00pm
Session Chair: Felipe van de Sande Araujo, Norwegian University of Science and Technology - NTNU
Micah Lucy Abigaba, School of Economics and Business, Norwegian University of Life Sciences, Norway
Jens Bengtsson, School of Economics and Business, Norwegian University of Life Sciences, Norway
Martijn Ketelaars, Tilburg School of Economics and Management, Tilburg University, Netherlands
Peter Kort, Tilburg School of Economics and Management, Tilburg University,, Netherlands
Discussant: Felipe van de Sande Araujo, Norwegian University of Science and Technology - NTNU
Building on earlier literature, we develop a framework for real options valuation of a sequential oil project. Investments at each sequential stage of oil project lifecycle are highly costly, lumpy and are sunk, for the most part, once expended. More so, each successive stage prior to the production stage typically does not lead to immediate cash flows but opens further investment opportunities. The capital intensity of oil investments, particularly at the development stage, makes them irreversible because the oil wells and operation facilities can only be used to produce oil. These complexities are exacerbated by the various uncertainties faced by these projects. Among these is the uncertainty about the oil price which influences the value of an oil project. Another is the uncertain time to completion of the preceding stages to production stage, particularly the development stage that requires large capital-intensive investments in facilities and infrastructure that take a long time to build. In particular, our framework applies Geometric Brownian Motion to model oil prices and incorporates an uncertain time to completion of the development phase. We obtain some closed form solutions for project values and threshold prices at which the firm should invest immediately. Finally, we undertake sensitivity analysis by varying some input parameters, such as oil price volatility and the expected duration of the development stage. Our case study is Uganda’s oil project in the Albertine Graben region. However, the framework is applicable to a broader range of real options involving lumpy, sequential and costly investments.
Danmo Lin, University of Warwick, United Kingdom
Du Liu, University of Oxford, United Kingdom
Elizabeth Whalley, University of Warwick, United Kingdom
Discussant: Jens Bengtsson, School of Economics and Business, Norwegian University of Life Sciences
We use a compound real options model to investigate the impact of product market characteristics on patent value by considering imperfect patent protection. Patent enforcement can be regarded as a portfolio of options. Once the patent lawsuit is filed, an alleged infringer firm (“challenger”) and an infringed firm (“incumbent”) pay for their ongoing litigation cost using operating cash flows from product market profits. We consider the challenger's strategy to exit the market during litigation due to shortage of funds, the incumbent's strategy to withdraw from value-reducing litigation or to force the challenger to exit the market by a threat to litigate, and firms' strategies to set up royalty payments to avoid a lawsuit, or to settle with each other after a lawsuit is filed. We distinguish between the effects of litigation and settlement on patent values and show first that settlement options raise patent values. By focusing on each firm's ability and willingness to pay for litigation costs, we find that product market characteristics such as the challenger's profit relative to the incumbent's loss of profits due to the alleged infringement (“gain-to-loss ratio”) has to be high enough for settlements to be possible. Settlements are also more likely in less volatile product markets, with more questionable patent validity, and when litigation costs are similar for the two firms. Our model generates new testable implications regarding patent values in a rigorous and comprehensive way.
Audun Midttun Systad, Norwegian University of Science and Technology - NTNU, Norway
Jens Løken Eilertsen, Norwegian University of Science and Technology - NTNU, Norway
Felipe van de Sande Araujo, Norwegian University of Science and Technology - NTNU, Norway
Ruud Egging-Bratseth, Norwegian University of Science and Technology - NTNU, Norway
Discussant: Danmo Lin, University of Warwick
The increased participation of renewable energy sources, while key to the green shift towards a future with lower carbon emissions, is adding more uncertainty to the electricity markets, due to source intermittency. The distributed aspect of new sources builds up the complexity and may stress the current balancing system. A market-based redispatch is a design intended to efficiently reward providers of flexibility in electricity markets. However, this design may present shortcomings, such as opening up for strategies where market power can be abused to obtain disproportionately high profits. One such strategy happens when power suppliers increase their output in the day-ahead market and decrease it in the real-time market, and this is known as inc-dec gaming. In this paper, we analyse to what degree producers can benefit from engaging in inc-dec gaming, and calculate the impact of measures that aim to prevent or mitigate the harmful effects of inc-dec gaming, and whether implementing these measures entails adverse side effects. An equilibrium problem with equilibrium constraints (EPEC) framework was developed to analyse these issues in a reduced market model with a day-ahead market and a real-time redispatch market. Results indicate that suppliers can abuse market power in order to obtain significant profits through inc-dec gaming. We find that there are effective measures to prevent and mitigate the adverse effects attributable to inc-dec gaming. However, the implementation of these measures brings a trade-off between the suppliers' profits, the system operator's costs, and the consumers' costs, and will not always increase general welfare.
Session Chair: Nick Huberts, University of York
Artur Rodrigues, University of Minho, Portugal
Discussant: Nick Huberts, University of York
This paper studies investment timing and leverage decisions of firms under caps and floors. Caps and floors have significant effects, not only on investment timing and firm value, but also on leverage ratios and credit spreads. With leverage, a floor has a moderate effect if below a critical level. Above that level, the firm tends to issue less risky debt, being even able to issue risk-free debt, and the floor has a more significant effect, accelerating investment. A lower cap deters investment, increases leverage, but reduces credit spreads. When combined with a floor, in a collar regime, the effects of the cap become non-monotonic, as the firm is able to issue risk-free debt for intermediate levels of the cap. Uncertainty always deters investment, but the effects on leverage and credit spreads are non-monotonic.
Richard Ruble, Emlyon Business School, France
Dimitrios Zormpas, CY Cergy Paris University, France
Discussant: Artur Rodrigues, University of Minho
We study how common ownership affects the timing and size of capacity investments by duopolists in ways that might lead to anticompetitive outcomes. Alongside accommodation and delay strategies, internalization also allows the leader to block follower entry permanently. We find that internalization magnifies the effect of leader capacity on the follower's capacity and timing, but at low internalization levels the leader still prefers to delay the follower at low demand states and accommodate at high demand states. At intermediate internalization levels, the leader may opt for a costly blockade at a low demand state if drift and volatility are high, and at a high demand state the outcomes resemble those of the static Stackelberg model. Finally, we show numerically that a small degree of internalization can be procompetitive by prompting the leader to switch to accommodation later.
Nick Huberts, University of York, United Kingdom
Jacco Thijssen, University of York, United Kingdom
Discussant: Richard Ruble, EM Lyon and GATE, CNRS
In response to the recent outbreak of the SARS-CoV-2 virus governments have aimed to reduce the virus's spread through, inter alia, non-pharmaceutical intervention. We address the question when such measures should be implemented and, once implemented, when to remove them. These issues are viewed through a real-options lens and we develop an SIRD-like continuous-time Markov chain model to analyze a sequence of options: the option to intervene and introduce measures and, after intervention has started, the option to remove these. Measures can be imposed multiple times. We implement our model using estimates from empirical studies and our main conclusions are that: (1) measures should be put in place almost immediately after the first infections occur; (2) if the epidemic is discovered when there are many infected individuals already, then it is optimal never to introduce measures; (3) once the decision to introduce measures has been taken, these should stay in place until the number of susceptible or infected members of the population is close to zero; (4) it is never optimal to introduce a tier system to phase-in measures but it is optimal to use a tier system to phase-out measures; (5) a more infectious variant may reduce the duration of measures being in place; (6) the risk of infections being brought in by travelers should be curbed even when no other measures are in place. These results are robust to several variations of our base-case model.
12:00pm - 1:15pm
Session Chair: Elizabeth Whalley, University of Warwick
Yishay Maoz, Department of Management and Economics, The Open University of Israel, Israel
Luca Di Corato, Università Ca' Foscari Venezia, Italy
Discussant: Richard Ruble, EM Lyon and GATE, CNRS
In a competitive industry where production entails pollution, a welfare-maximizing policy maker considers, as control instruments, setting a cap on market output or levying an emission tax. We embed this scenario within a dynamic setup where market demand is stochastic and entry is irreversible. We firstly determine the industry equilibrium under both policies and then the cap level and the tax rate maximizing welfare. Our main findings are: (i) the optimal tax policy dominates the optimal cap policy; (ii) the optimal tax policy implements the first-best outcome.
Yishay Maoz, Department of Management and Economics, The Open University of Israel, Israel
Richard Ruble, EM Lyon and GATE, CNRS, France
Discussant: Elizabeth Whalley, University of Warwick
In competitive industries, foreseeable policy changes lead to inevitable runs which increase the volatility of investment. We show that this phenomenon, well-known in the case of caps and quotas, also applies to taxes and subsidies, and occurs whether policy changes apply only to new entrants or to all firms equally. Looking at the case of raising taxes (or removing a subsidy) we find that runs are smaller when the policy change affects all firms. We also find that the size of the run, i.e., the size of the resulting increase in market quantity is increasing in the magnitude of the tax raise. Finally, we show that during the run firms invest faster and more massively than on the socially optimal path, and therefore welfare decreases. We show that these results have implications for a broad range of policies, such as the removal of renewable energy subsidies in some European countries.
A Elizabeth Whalley, Warwick Business School, United Kingdom
Discussant: Luca Di Corato, Università Ca' Foscari Venezia
We build a real options model to investigate the optimal amount of payments to landowners for conservation and the optimal timing of their introduction. Such subsidy contracts, which require landowners to conserve land and preclude development, can be used to increase ecosystem services (ESS) provided by the land and/or preserve existing ESS, which would be lost if development occurs. They enhance ESS provision both directly, once the contract has been accepted by the landowner, and also indirectly, by delaying development. Governments and other public bodies trade off the value of the flow of ESS benefits generated by the land with the costs of providing the subsidy. Increasing the (permanent) level of subsidy increases the government's cost and hence reduces value once the landowner accepts the conservation contract, but increases the present value of the ESS benefits by increasing the expected time until development occurs. The level of subsidy that maximises expected ESS value net of subsidy costs thus varies with the relative proximities of the development and conservation contract acceptance thresholds. Assuming that the announcement of a subsidy level is irreversible, we determine the optimal subsidy level and threshold at which the announcement is made. We plan to investigate the impacts on landowner thresholds and optimal subsidies of different expected conservation contract durations and political risk, whereby such subsidised conservation contracts are available only temporarily.
Session Chair: Grzegorz Pawlina, Lancaster University
Yuri Lawryshyn, University of Toronto, Canada
Xuan Ze Li, University of Toronto, Canada
Discussant: Grzegorz Pawlina, Lancaster University
Previously, we introduced a methodology based on exercise boundary fitting in an effort to develop a practical Monte Carlo simulation-based real options approach. We showed that our methodology converges in the case of simple Bermudan and American put options. More recently, we expanded on the model to solve a staged manufacturing problem. As we presented, utilizing boundary fitting allowed us to solve a computationally difficult problem. In another study we explored the use of the boundary fitting methodology for a number of cases, one being a build and abandon mining example. We showed that while the methodology provided good convergence on option value, under certain scenarios, where the optimal exercise boundaries occurred in regions where there were few Monte Carlo paths, the optimization algorithm struggled to converge. The purpose of this paper is to explore convergence issues related to the boundary fitting methodology. Specifically, we develop experiments where we compare our boundary fitting methodology with pseudo-analytical or numerical results for the following cases: Bermudan put option; option to purchase a Bermudan put option; American put option; and build / abandon real option.
Farzan Faninam, Tilburg University, Netherlands
Kuno Huisman, Tilburg University, Netherlands
Peter Kort, Tilburg University, Netherlands
Juan Vera, Tilburg University, Netherlands
Discussant: Yuri Lawryshyn, University of Toronto
We analyze the investment decisions under uncertainty in oligopoly markets by considering a market of many firms with asymmetric cost structure in a discrete time setting where the demand evolves stochastically and follows a linear structure. Considering competitive strategies, increasing the number of firms imposes inevitable complexities to the model structure. We propose a new approach, based on reinforcement learning, to numerically solve the investment timing problem when the number of firms increases. Our approach can be more generally applied to investigate markets of many firms with several investment opportunities.
Argyro Panaretou, Lancaster University, United Kingdom
Grzegorz Pawlina, Lancaster University, United Kingdom
Qifan Zhai, South China University of Technology, China
Discussant: Farzan Faninam, Tilburg University
We propose a model of credit rating migrations that allows for the possibility of rating stickiness. The model aims to capture the mechanism of the rating process, based on the notion of hysteresis in real option models, that underlies the behavior of rating agencies and is used to explain the observed gradual deterioration in ratings. The paper contributes to the ongoing debate whether the downward trend in credit ratings results from the deteriorating credit quality or tightening rating standards. It is shown that corporate credit quality actually slightly improves over time and that there is asymmetry in rating migrations as upgrades become increasingly more difficult, while downgrade standards remaining unchanged.


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