Option valuation of flexible investments

This paper examines the use of contingent claim analysis to evaluate the option of retrofitting a coal gasifier on an existing gas-fired power plant in order to take advantage of changes in the relative prices of natural gas and coal. Commodity price changes over time were modeled by binomial stochastic processes, and the price of natural gas is first assumed to follow a Wiener process over time. The option to wait before retrofitting the gasifier was found to be very valuable to the utility. The volatility and convenience yield of natural gas prices were shown to have a strong influence on the exact option value. Uncertainties surrounding future gasifier capital costs proved to be less critical. The paper also examined the case where the price of natural gas follows a mean-reverting process over time, and found that the option value can be substantially affected.