Real options analysis of investment in solar vs. wind energy: Diversification strategies under uncertain prices and costs

Ardjan Gazheli, Jeroen van den Bergh

Index: 10.1016/j.rser.2017.09.096

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Abstract

In this paper we study a community or firm considering to diversify its investment in two distinct renewable energy technologies, namely wind and solar PV electricity. We assume technological learning curves as a function of cumulative capital investment. A real options approach is applied as it takes into account uncertainty about prices and learning, as well as irreversibility associated with investment decisions. We investigate three different cases, dealing with uncertainty about future electricity prices, and uncertainty about the speed with which learning drives the costs of wind and solar electricity down. We assess the minimum threshold for the stochastic price and the maximum electricity production cost that makes it optimal for the firm to invest in the two technologies. The results show that the learning rate affects the option to invest in but reducing critical threshold for exercising it. The greater the amount of capital invested, the more learning stimulates earlier exercising of the option to invest. The firm will then anticipate the option to invest and exercise it for lower critical threshold values if all capital is invested in one technology. If capital investment is diversified, the option should be exercised at a higher critical threshold. More uncertainty in energy prices or technology costs postpones the option to invest. Although investing in both solar and wind may be profitable under particular conditions of price and cost uncertainty, the theoretically optimal strategy is generally investing in only one technology, that is, solar or wind, depending on their relative initial costs and learning rates. This suggests that the practice in most countries of diversifying renewable energy may reflect a mistaken strategy.