Investment under uncertainty: application of binomial option analysis to development of geothermal energy in Indonesia

Abstract

Indonesia has identified a large amount of geothermal resource potential throughout the islands. However, geothermal utilization is presently low. One of the main reasons is due to limited government funds to develop the resources. Another contributing factor is the high prices charged by private geothermal electricity producers, which was part of the reason why the government suspended most private geothermal development projects. The common perception blames corruption, collusion and nepotistic behavior of the market participants for this unfortunate situation. This research shows that even if opportunistic behavior is cast away, the present business arrangement corresponds to an incentive system that brings about high geothermal electricity prices. Applying the Real Option Theory reveals that managerial flexibility in the decision-making process of a geothermal project is valuable, since it allows the use of updated information. In contrast to the present ex-ante price determination setting, a possible way to incorporate flexibility is to agree on output price after exploration activities are concluded. Under certain conditions, this ex-post price determination setting may produce a wider range of feasible prices that includes those lower than the ex-ante price. As such, incorporating flexibility into the decision process improves project value and may lower its output price. The research model implicitly assumes the first-best world with respect to the assumptions of symmetric information and a simple self-interest behavior. These two assumptions set the limitation of the model results. In a complex world with incomplete and asymmetric information as well as opportunistic behavior of the market participants, the ex-post price determination is likely to fail due to reciprocal concerns of the parties. A two-phased negotiation system may attenuate the opportunism concerns, while provides assurance that only viable projects can survive.