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Real Option Valuation in a Gollier/Weitzman World: The Effect of Long-Run Discount Rate Uncertainty

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  • Djerry C. Tandja M., Gabriel J. Power, and Josée Bastien

Abstract

Large-scale investment projects face significant long-run uncertainty in interest rates. However, little is known about the effect of long-term discount rate uncertainty on capital investment real option values. This paper bridges the long-run discount rate uncertainty literature developed in climate change economics with the financial literature on interest rate models and real options. First, we derive an Ingersoll-Ross real option model under the assumption of a declining discount rate model (DDR) following Gollier and Weitzman, and show how optimal investment timing is affected. Second, we study the problem of an open oil field with an abandonment option. We find that, compared with DDR, standard models using constant or mean-reverting interest rates undervalue projects and their real options to wait or to abandon. Indeed, results under DDR are more consistent with recent evidence on corporate decision-making under incomplete preferences or ambiguity. The results have implications for both energy investment under uncertainty and climate finance.

Suggested Citation

  • Djerry C. Tandja M., Gabriel J. Power, and Josée Bastien, 2018. "Real Option Valuation in a Gollier/Weitzman World: The Effect of Long-Run Discount Rate Uncertainty," The Energy Journal, International Association for Energy Economics, vol. 0(Number 5).
  • Handle: RePEc:aen:journl:ej39-5-power
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    Cited by:

    1. Boqiang Lin & Siquan Wang, 2023. "Mechanism analysis of the influence of oil price uncertainty on strategic investment of renewable energy enterprises," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 28(4), pages 4176-4193, October.

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    JEL classification:

    • F0 - International Economics - - General

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