Making real options credible: Incomplete markets, dynamics and model ambiguity

Investment decisions in the energy industry are often undertaken sequentially and are sensitive to information regarding energy markets and geographic conditions. Information may arrive gradually over time and as a consequence of early stage decisions. Therefore, NPV-based frameworks are unsuitable for decision making because they do not allow for the fact that new information may change later stage decisions. Real option valuation (ROV) serves as an effective evaluation tool for projects with flexibilities. However, it has remained a fringe field; practitioners believe it is not practically applicable in complex real world environments. The reason is that the real-life problems violate basic assumptions required by standard option pricing techniques. This thesis therefore aims to provide feasible solutions by applying real option theory to several highly complex energy problems with unhedgeable risks, complicated underlying dynamics, and model ambiguity taken into consideration.