The use of Real Options for investment decision-making in an emerging LNG infrastructure.

Abstract

Europe’s transport sector is predominantly fuelled by oil products, fuels which are finite and emit large amounts of greenhouse gasses (i.e. CO2 and NOx) upon combustion. Therefore the sector is faced with stricter emission control regulations in the coming decade. The use of liquefied natural gas (LNG) as a fuel has shown prosperous results for reducing these emissions. Because of LNG’s properties and the inherent changes in regulations, LNG is an attractive alternative to improve on the current situation. However, the use of LNG as a fuel requires immense investments in infrastructure which are, by definition, impeded by a classic chicken-and-egg problem. The supply side of LNG will not establish an infrastructure until sufficient demand arises, and end-users have to retrofit or even replace their fuel systems and engines. Both are faced with large amounts of uncertainty on lumpy investment decisions. As the world’s largest independent tank storage provider, Vopak’s LNG department would like to provide the necessary infrastructure. However, one of the problems that Vopak is currently facing is that some important investment decisions are deferred due to the current valuation methods. Risks are translated into high contingency costs, which are added to the costs of the investment proposal. Moreover, as the LNG value chain is transforming radically in the coming decade, Vopak experiences even more uncertainty. The company is in need of new evaluation methods to cope with these uncertainties. The problem owner’s traditional decision-making process and financial methods are no longer accurate to evaluate investment proposals faced with a high level of uncertainty, and it calls for a new valuation method. A literature study and case study has been conducted to structure this research. The literature study describes a number of alternative financial methods that are more robust in dealing with high levels of uncertainty. Most alternatives have the goal to fight this uncertainty. However, by applying real option theory, a combination of financial options theory and decision analysis, the focus is placed on flexibility to co-exist with uncertainty. Moreover, it concentrates on exploiting uncertainty as it will create risks but also opportunities. In the Case Study two alternatives based on the real options principle, are compared to the traditional approach on the development of an LNG truck loading bay at the Gate terminal in Rotterdam, the Netherlands. The case study results were presented to the LNG department of Royal Vopak N.V. and a survey was held to gather feedback on the results. Subsequently the following research question is answered in this study; What are the advantages and disadvantages of using real options in uncertain investment decisions for Vopak in the context of an emerging LNG infrastructure? The advantages of using real options for investment decision-making at Vopak are that these two alternative methods have shown their (strategic) value when they are applied on Vopak’s initial investment proposal of the LNG truck loading bay. The first alternative, real option analysis, provides significantly more insights in the underlying assumptions and choices determining the investment decision. The case study results show that Vopak would benefit more by constructing two or three LNG truck loading bays, instead of one as planned originally. The second alternative, designing for flexibility, provides the opportunity to quantitatively substantiate the choice to incorporate flexible design option in the design of such truck loading bay. Both alternatives are designed as financial modelling tools in Microsoft Excel ®. On the contrary, disadvantages of using real options became clear after presentation of the case study results; managers perceive switching to a different valuation method as a barrier. Furthermore, significant resources (i.e. extra knowledge, time and money) are required to implement the real options principle, yet the problem owner has no outlook on a possible success. These necessary investment process changes are rarely mentioned in current real options literature. Therefore this study also presents an implementation procedure for the above mentioned alternatives. The problem owner is seriously interested in incorporating the mind-set behind real options (considering flexibility) in their traditional valuation approach. In order to actually implement the proposed methods in larger and other projects, more case studies at Vopak are required. Future research should focus on the explicit linkage between infrastructure investments and the use of real options. The real options concept, and especially the methodology behind designing for flexibility, can potentially provide more insights on infrastructure investments when they are considered to be social-technical systems which are being developed under competition or cooperation.