Energy Investments: An Adaptive Approach to Profiting from Uncertainties

508 Pages·2017·9.73 MB·English

by  Ricardo G. Barcelona (auth.)

E N E R G Y
I N V E S T M E N T S
An Adaptive Approach to
Profiting from Uncertainties
RICARDO G. BARCELONA
Energy Investments
Ricardo G. Barcelona
Energy Investments
fi
An Adaptive Approach to Pro ting
from Uncertainties
Ricardo G.Barcelona
IESE BusinessSchool
University ofNavarra
Barcelona
Spain
ISBN978-1-137-59138-8 ISBN978-1-137-59139-5 (eBook)
DOI10.1057/978-1-137-59139-5
LibraryofCongressControlNumber:2017939327
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Initial Endowments
Jesus M. Zulueta Jr+
Humanist and a friend, from whose life and good humour we learned to
’
transform and act on life s uncertainties as avenues to scale new heights
Santiago Sr+ and Magdalena Go Lieng+ Barcelona
Living the ordinary extraordinarily well, the generations that follow
are endowed with a culture of integrity, service and excellence
Antonio Sr+ and Clotilde+ Ortega Carballo
Beloved by people, from whence true wealth and power emanate,
they converted barren lands into thriving communities
The Commitments
Jonelyn
Wife, mother of our children, loyal friend and partner, through
her commitments new pathways open
Options
Jasmine, Ainhoa Itziar, and Chantal Beatriz
In whose hands lay the power to choose to follow, or to blaze new paths
to create feasible futures
Advance Praise from Academe
and Policymakers
“Theenergyindustryisatacrossroad.Theparadigmischangingalthoughtheuncertaintyaround
newtechnologyandlackofclearorientationfrompolicyandregulatoryperspectivesmakesfirms’
decision-making more complex. It also raises some expectations in our society that may not be
delivered in the medium-term. Ricardo’s book offers a rigorous platform to better frame some
energy decisions—both at policy and company levels—and offer consistent answers to this very
relevant societal challenge.”
—Jordi Canals, DeanEmeritus andProfessorof IESEBusiness School, Spain/USA
“Shifting European Union policy, falling energy prices, and increased costs of production are a
cocktailthatdoesnotbodewellforfossilfuel-basedenergysupplies.Renewablessubsidiesaddto
energy prices that burden citizens and industry. These circumstances push energy managers and
policymakers to seek innovative solutions to producing energy and financing investments. This
bookisa thoughtfulcontribution toaddressing theseissues—and resolving thesedilemmas.”
—Krzysztof Tchórzewski,Minister of Energy,Government of Poland
“Ricardo has performed the Herculean task of integrating several literature streams into a sound
framework for energy finance practitioners. The idea of applying dynamic tools from modern
finance theoryto energyeconomics andpolicy iscommendable.”
—Dr.Tarik Driouchi,Reader in FinancialManagement, King’sCollege London, UK
“The author questions the accepted wisdoms of capital budgeting, proposes an alternative, and
makes real options and option games into analytical tools accessible to managers. Real-life cases
illustrate thesimplicity andpower ofthe ideas behind theproposed framework.”
—Bernardo M.Villegas,Co-founder, University ofAsia andthe Pacific,andformer member,
Constitutional Commission, Metro Manila, Philippines
“The book is of interest to policymakers, as it is one of the few available resources that has a
practical take on clarifying how the energy business interacts within dynamic policy and market
vii
viii AdvancePraisefromAcademeandPolicymakers
environmentssuchasIndonesia.Aspolicymakers,wehavetopursuepoliciesthatseektoupliftour
people’s well-being. The Coal-Geothermal swap idea that Barcelona and Antonie de Wilde offer
couldpavethewaytomeetingIndonesia’senergyneeds,andsatisfiesourConstitution’sArticle33
that ensures our people benefits from our natural resources while satisfying our environmental
targets underCOP21.”
—Dr.IrMontty Girianna,Deputy Minister in theCoordinating Ministry forEnergy and
Mining, Government ofIndonesia, Jakarta, Indonesia
“Instructiveandtimely,thebookisapragmaticandthoughtfulreadforenergypractitionersand
policymakers ata timewhenuncertainty in the industryiscertain.”
—Raphael P.M.Lotilla,Independent Director,Trans-Asia Petroleum, andformer Secretary of
Energy,Government of the Philippines
“As Philippine Ambassador to the Netherlands from 2002 to 2009, I had the opportunity to
interact with Dr Barcelona on energy issues affecting the Philippines. The National Power
Corporation of the Philippines has availed of his expertise during Fidel V Ramos’s presidency in
formulating aviable andsustainable energy policy forthe country.”
—Romeo Arguelles,former Philippine Ambassador to theNetherlands, United States
Early Praise from Practitioners
“Analternativeapproachisproposedtohedgeenergymarketandtechnologyuncertainties,andin
the process,firmscanprofit fromthe opportunities offered byrenewables.”
—EmilioLamo Espinosa,Chairman, Elcano Royal Institute, Spain
“Knowntomeforthepastthirtyyears,Ricardoisrecognisedasoneofthetopratedenergyexperts.
He combines his experiences and strategic insights gained from industry and finance in his new
book—an extremely valuable resource foranyone whowants to beup to date in such a strategic
industry.”
—PabloDiaz Megias,Country Head,UBS Group, Spain
“This book’s approach aims to include issues around price, costs and volume volatilities—very
relevant in the light of current volatile energy markets—into the overall cost/benefit calculation
when choosing a power generation technology. ‘Traditional’, deterministic approaches are no
longer sufficient. A colleague at Shell, Dr. Barcelona’s hands-on experience in various energy
markets means thatthis bookis writtenforpractitioners byapractitioner.”
—William Sooby,Energy Consultant,United Kingdom, andformerly Shell Energy Europe,
TheNetherlands
“Ifyouwanttobenefitfrominnovativestrategicinsightsregardinginvestingintheenergysector,
resultingfromafreshout-of-the-boxapproachbytheauthor,thenthisbookdoesexactlythat.The
authornot only providepractical methodsbutalso showapplications inreal life.”
—Gert-JanMonster,SeniorInvestmentOfficer,FMO—ThedevelopmentbankoftheNetherlands
AdvancePraisefromAcademeandPolicymakers ix
“Dr.RicardoBarcelona’sbookisatruepractitioners’guideforenergyfinanceandamustreadfor
anyone interested inthe energy sector.”
—Carlos Reyes, Principal, IFCAsset Management Company LLC,Director, United States
“Repeatedleadershipfailuresare maskedwhenbusinesslogicislostthroughthesimplisticuse of
financial methodologies in capital budgeting and investment evaluation. This book shows
straightforward practical solutions to counter them, while highlighting opportunity and choice.
Quitesimply, managers are offeredthe opportunity todo the rightthings the right way.”
—Paul Collin,former Group Vice-President, HumanResources, ABB,Zurich, Switzerland
Preface
Imagine walking into a banquet. At each table guests are engrossed in
conversations. Walking around the hall, you observe some people going in
and out of conversations, while others linger and become fully engaged.
Before deciding to join one ofthe tables,youask yourself which conversation
youwant to contribute to, and why the other guests should bother withwhat
you have to say.1
’
The conversations about energy at the managers table revolve around
“ ”
how to supply , and their conclusions focus on resource economics and
technology. At another table policymakers concentrate on environmental
and sustainability issues, and the divide between continued fossil fuels usage
’
and promoting renewables. The consumers table istorn between demanding
clean energy and whether itis fairtopay subsidies. Each group being stuck at
its own table with a narrow world view, issues are obscured and causes are
advocated, preventing meaningful dialogues from taking place. To redirect
these conversations, our long-held beliefs and systems need to be reframed.
’
For example, capital budgeting is an article offaith at the managers table
fl
thatisdueforreframing. Foundedonthepremisethatcertaintyincash ows
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ispreferred,investmentswithpredictablecash owsachievethehighestvalue.
This truism has taken on the stature of biblical truth for managers. Where
— —
else can a single number net present value (NPV) hold sway, alighting
managerial passions and transforming ideas into commercial reality?
This faith in the certainty of NPV is greatly shaken when reality diverges
fi
from the well-ordered world that nance presumes. In an uncertain world,
small changes in costs, prices, volumes or discount rates radically alter the
decision to commit or defer. This uncertainty is problematic: without
xi
xii Preface
intending to, managers often inadvertently focus their minds on getting the
“ ” fi
right answers to champion favoured investments, while nding reasons to
“ ”
reject competing opportunities that are wrong . Consequently, the decision
to commit boils down to competition among managerial interests (and per-
“ ” fi
haps ego). Looking back on non-rational decisions in the eld, Lenos
Trigeorgis has asserted that maybe capital budgeting as described has con-
tributed to western firms’ economic under-performance and decline.2
The dilemma around the proposed Hinkley Point C nuclear facility is a
fl
case in point. The prospect of large investment in ow excites the United
Kingdom government because of the jobs it creates. The prospect of reviving
the French nuclear industry is viewed favourably in France. To attract
funding, the latest being from China, capital commitments are aligned with
fl
expected cash ows that justify commitment by Electricité de France, sup-
fi
ported with sizeable subsidies. Fast forward to when the nal investment
decision is going to be taken, and cost estimates have escalated that threaten
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to unravel the well-crafted nancial balance. As consumers realise how much
the electricity will cost them, benign neglect turns to hardened protests. But
’ fi
weren t the nancial circumstances looking viable, you may be forgiven for
asking? Indeed they were, except that another cost estimate escalation will
— fi
wipe out any returns and this is before the rst brick is laid at the site.
fi
Fortunately for modern nance and strategy, a different narrative is chal-
lenging the entrenched certainty notions. Avinash Dixit,3 in introducing the
works of Benoit Chevalier-Roignant and Lenos Trigeorgis on option games,
“
offers an alternative formulation: When facing an uncertain future,
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remaining exible until more information arrives has value, because one can
cherry pick to make investments only when the prospects are relatively
favourable. This is the starting intuition of real options theory. But in game
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theory, the strategy of making irreversible commitments to seize rst-mover
advantage and present rival players with a fait accompli to which they must
”
adapt can have its own value. Dixit continues to observe that managers are
“
faced witha question: What does one do when facing an uncertain future in
”
the company of rivals? He credits the work of Chevalier-Roignant and
Trigeorgis as providing an invaluable starting point for future work in this
fi
eld.
Option-games reasoning provides better ways to untangle complex deci-
sions in the uncertain world of energy investments. Providing a coherent
language and framework, option games could link a number of the disparate
conversations, often conducted in isolation, among policymakers and the
managerial ranks.
fi
The ability to link strategy with nance in a coherent frame has value. In
formulating good strategies, Richard Rumelt starts with the intuitions that