Valuing flexibility in electro-intensive industries: the case of an aluminum smelter
Bastian-Pinto, Carlos de Lamare; Brandão, Luiz Eduardo Teixeira; Ozório, Luiz de Magalhães
http://dx.doi.org/10.1590/0103-6513.174214
Production, vol.26, n1, p.28-38, 2015
Abstract
Electro-intensive industries account for a significant proportion of the total industrial electricity consumption, and these industries usually possess co-generation assets, which can supply at least part of their energy needs. However, due to price uncertainty, it may be optimal for the firm to temporarily suspend production and sell the available energy. If this strategy creates value, governments can create incentives through price signals for these firms to take their plants offline and increase the supply of electricity during times of shortage. This study analyzes the case of an aluminum plant that has the choice of temporarily suspending operations and models its managerial flexibility as a bundle of European switch options. The suspension and modeling would occur under two simultaneous situations, uncertainty and asymmetric state switching costs under the real options approach, to determine whether the changes add value to the firm. The results indicate that this flexibility can add significant value to the firm.
Keywords
Switch options. Asymmetric switching costs. Managerial flexibility. Aluminum industry.
References
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Bastian-Pinto, C., Brandão, L., & Hahn, W. J. (2009). Flexibility as a source of value in the production of alternative fuels: The ethanol case. Energy Economics, 31(3), 411-422. http://dx.doi.org/10.1016/j.eneco.2009.02.004
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Dixit, A., & Pindyck, R. (1994). Investment under uncertainty. Princeton: Princeton University Press.
Dockendorf, J., & Paxson, D. (2013). Continuous rainbow options on commodity outputs: what is the real value of switching facilities? The European Journal of Finance, 19(7-8), 645-673. http://dx.doi.org/10.1080/1351847X.2011.601663
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Merton, R. C. (1973). Theory of rational option pricing. The Bell Journal of Economics and Management Science, 4(1), 141-183. http://dx.doi.org/10.2307/3003143
Morck, R., Schwartz, E., & Stangeland, D. (1989). The valuation of forestry resources under stochastic prices and inventories. Journal of Financial and Quantitative Analysis, 24(4), 473-487. http://dx.doi.org/10.2307/2330980
Ozorio, L., Bastian-Pinto, C. L., Baidya, T. K. N., & Brandão, L. E. T. (2013). Investment decision in integrated steel plants under uncertainty. International Review of Financial Analysis, 27, 55-64. http://dx.doi.org/10.1016/j.irfa.2012.06.003
Paddock, J. L., Siegel, D. R., & Smith, J. L. (1988). Option valuation of claims on real assets: the case of offshore petroleum leases. Quarterly Journal of Economics, 103(3), 479-508. http://dx.doi.org/10.2307/1885541
Pindyck, R. S. (1999). The long-run evolution of energy prices. Energy Journal, 20(2), 1-27. http://dx.doi.org/10.5547/ISSN0195-6574-EJ-Vol20-No2-1
Schwartz, E. S. (1997). The stochastic behavior of commodity prices: implications for valuation and hedging. Journal of Finance, 52(3), 923-973. http://dx.doi.org/10.1111/j.1540-6261.1997.tb02721.x
Siegel, D. R., Smith, J. L., & Paddock, J. L. (1987). Valuing offshore oil properties with option pricing models. Midland Corporate Finance Journal, 5, 22-30.
Slade, M. (2001). Valuing managerial flexibility: an application of real-option theory to mining investments. Journal of Environmental Economics and Management, 41(2), 193-233. http://dx.doi.org/10.1006/jeem.2000.1139
Trigeorgis, L. (1990). A real options application in natural resource investments. Advances in Futures and Options Research, 4, 153-164.
Tufano, P. (1998). The determinants of stock price exposure: financial engineering and the gold mining industry. Journal of Finance, 53(3), 1015-1052. http://dx.doi.org/10.1111/0022-1082.00042
Bastian-Pinto, C., Brandão, L., & Alves, M. L. (2010). Valuing the switching flexibility of the ethanol-gas flex fuel car. Annals of Operations Research, 176(1), 333-348. http://dx.doi.org/10.1007/s10479-009-0514-7
Bastian-Pinto, C., Brandão, L., & Hahn, W. J. (2009). Flexibility as a source of value in the production of alternative fuels: The ethanol case. Energy Economics, 31(3), 411-422. http://dx.doi.org/10.1016/j.eneco.2009.02.004
Berger, M. C. (1988). Predicted future earnings and choice of College Major. Industrial and Labor Relations Review, 41(3), 418-429. http://dx.doi.org/10.2307/2523907
Bessembinder, H., Coughenour, J. F., Seguin, P. J., & Smoller, M. M. (1995). Mean reversion in equilibrium asset prices: evidence from futures term structure. Journal of Finance, 50(1), 361-375. http://dx.doi.org/10.1111/j.1540-6261.1995.tb05178.x
Black, F., & Scholes, M. (1973). The pricing of options and corporate liabilities. The Journal of Political Economy, 81(3), 637-654. http://dx.doi.org/10.1086/260062
Brennan, M. J., & Schwartz, E. S. (1985). Evaluating natural resource investments. Journal of Business, 58(2), 135- 157. http://dx.doi.org/10.1086/296288
Byko, M. (2002). TMS plenery symposium: energy reduction in the aluminum industry. Journal of Minerals, Metals and Materials Society, 54(5), 39-40. http://dx.doi.org/10.1007/BF02701695
Das, S., Long III, W. J., Hayden, H. W., Green, J. A. S., & Hunt Jr., W. H. (2004). Energy implications of the changing world of aluminum metal supply. JOM, 56(8), 14-17. http://dx.doi.org/10.1007/s11837-004-0175-6
Dias, M. A. G., & Rocha, K. (1999). Petroleum concessions with extendible options using mean reversion with jumps to model oil prices. In 3rd Annual International Conference on Real Options, Leiden, Netherlands.
Dixit, A., & Pindyck, R. (1994). Investment under uncertainty. Princeton: Princeton University Press.
Dockendorf, J., & Paxson, D. (2013). Continuous rainbow options on commodity outputs: what is the real value of switching facilities? The European Journal of Finance, 19(7-8), 645-673. http://dx.doi.org/10.1080/1351847X.2011.601663
Fontoura, C. F., Brandão, L. E., & Gomes, L. L. (2014, in press). Elephant grass biorefineries: towards a cleaner Brazilian energy matrix? Journal of Cleaner Production. Kulatilaka, N. (1993). The value of flexibility: the case of a dual-fuel industrial steam boiler. Financial Management, 22(3), 271-280. http://dx.doi.org/10.2307/3665944
Merton, R. C. (1973). Theory of rational option pricing. The Bell Journal of Economics and Management Science, 4(1), 141-183. http://dx.doi.org/10.2307/3003143
Morck, R., Schwartz, E., & Stangeland, D. (1989). The valuation of forestry resources under stochastic prices and inventories. Journal of Financial and Quantitative Analysis, 24(4), 473-487. http://dx.doi.org/10.2307/2330980
Ozorio, L., Bastian-Pinto, C. L., Baidya, T. K. N., & Brandão, L. E. T. (2013). Investment decision in integrated steel plants under uncertainty. International Review of Financial Analysis, 27, 55-64. http://dx.doi.org/10.1016/j.irfa.2012.06.003
Paddock, J. L., Siegel, D. R., & Smith, J. L. (1988). Option valuation of claims on real assets: the case of offshore petroleum leases. Quarterly Journal of Economics, 103(3), 479-508. http://dx.doi.org/10.2307/1885541
Pindyck, R. S. (1999). The long-run evolution of energy prices. Energy Journal, 20(2), 1-27. http://dx.doi.org/10.5547/ISSN0195-6574-EJ-Vol20-No2-1
Schwartz, E. S. (1997). The stochastic behavior of commodity prices: implications for valuation and hedging. Journal of Finance, 52(3), 923-973. http://dx.doi.org/10.1111/j.1540-6261.1997.tb02721.x
Siegel, D. R., Smith, J. L., & Paddock, J. L. (1987). Valuing offshore oil properties with option pricing models. Midland Corporate Finance Journal, 5, 22-30.
Slade, M. (2001). Valuing managerial flexibility: an application of real-option theory to mining investments. Journal of Environmental Economics and Management, 41(2), 193-233. http://dx.doi.org/10.1006/jeem.2000.1139
Trigeorgis, L. (1990). A real options application in natural resource investments. Advances in Futures and Options Research, 4, 153-164.
Tufano, P. (1998). The determinants of stock price exposure: financial engineering and the gold mining industry. Journal of Finance, 53(3), 1015-1052. http://dx.doi.org/10.1111/0022-1082.00042
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