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Valuing the switching flexibility of the ethanol-gas flex fuel car

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  • Carlos Bastian-Pinto
  • Luiz Brandão
  • Mariana Lemos Alves

Abstract

Renewable energy sources are becoming more important as the world’s supply of fossil fuels decrease and also due to environmental concerns. Since 2003, when the ethanol-gasoline flex fuel car became commercially available in Brazil, the growth of this market has been significant, to the point where currently more than 50% of the fuel consumption of cars in Brazil is from renewable biofuels (ethanol). This has been made possible due to the success of the flex fuel car, which can run on ethanol, gasoline, or any mix of these in the same fuel tank, and which is sold at a premium over the non-flex models. Flex fuel cars, on the other hand, provide the owner with the flexibility to choose fuels at each refueling stop. Given the uncertainty on future prices of ethanol and gas, this option adds value to the owner since he can always opt for the cheaper fuel whenever he fills up his car. We use the Real Options method to analyze the value of the flex fuel option assuming both a Geometric Brownian Motion and Mean Reverting diffusion processes for the prices of gasoline and ethanol and compare the results arising from both methods. We conclude that the flex option value is significant using either method and twice as high as flex premium charged by the car manufacturers, which helps explain the success that this type of automobiles have gained in Brazil since 2003. Our results also indicate that consumers should be willing to purchase flex fuel cars even if manufacturers increase the flex premium. Copyright Springer Science+Business Media, LLC 2010

Suggested Citation

  • Carlos Bastian-Pinto & Luiz Brandão & Mariana Lemos Alves, 2010. "Valuing the switching flexibility of the ethanol-gas flex fuel car," Annals of Operations Research, Springer, vol. 176(1), pages 333-348, April.
    • Handle: RePEc:spr:annopr:v:176:y:2010:i:1:p:333-348:10.1007/s10479-009-0514-7
    DOI: 10.1007/s10479-009-0514-7
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    References listed on IDEAS

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    1. Schwartz, Eduardo S, 1997. "The Stochastic Behavior of Commodity Prices: Implications for Valuation and Hedging," Journal of Finance, American Finance Association, vol. 52(3), pages 923-973, July.
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    Cited by:

    1. Taylor-de-Lima, Reynaldo L.N. & Gerbasi da Silva, Arthur José & Legey, Luiz F.L. & Szklo, Alexandre, 2018. "Evaluation of economic feasibility under uncertainty of a thermochemical route for ethanol production in Brazil," Energy, Elsevier, vol. 150(C), pages 363-376.
    2. Alexander, Carol & Chen, Xi & Ward, Charles, 2021. "Risk-adjusted valuation for real option decisions," Journal of Economic Behavior & Organization, Elsevier, vol. 191(C), pages 1046-1064.
    3. Ana Garcia-Bernabeu & Antonio Benito & Mila Bravo & David Pla-Santamaria, 2016. "Photovoltaic power plants: a multicriteria approach to investment decisions and a case study in western Spain," Annals of Operations Research, Springer, vol. 245(1), pages 163-175, October.
    4. Bertolini, Marina & D'Alpaos, Chiara & Moretto, Michele, 2018. "Do Smart Grids boost investments in domestic PV plants? Evidence from the Italian electricity market," Energy, Elsevier, vol. 149(C), pages 890-902.
    5. Alcino Azevedo & Dean Paxson, 2018. "Rivalry and uncertainty in complementary investments with dynamic market sharing," Annals of Operations Research, Springer, vol. 271(2), pages 319-355, December.
    6. Ghoddusi, Hamed, 2017. "Blending under uncertainty: Real options analysis of ethanol plants and biofuels mandates," Energy Economics, Elsevier, vol. 61(C), pages 110-120.
    7. Sendstad, Lars Hegnes & Chronopoulos, Michail, 2020. "Sequential investment in renewable energy technologies under policy uncertainty," Energy Policy, Elsevier, vol. 137(C).
    8. Brito, Thiago Luis Felipe & Islam, Towhidul & Stettler, Marc & Mouette, Dominique & Meade, Nigel & Moutinho dos Santos, Edmilson, 2019. "Transitions between technological generations of alternative fuel vehicles in Brazil," Energy Policy, Elsevier, vol. 134(C).
    9. Das Gupta, Supratim, 2021. "Using real options to value capacity additions and investment expenditures in renewable energies in India," Energy Policy, Elsevier, vol. 148(PA).
    10. Tenkorang, Frank & Dority, Bree L. & Bridges, Deborah & Lam, Eddery, 2015. "Relationship between ethanol and gasoline: AIDS approach," Energy Economics, Elsevier, vol. 50(C), pages 63-69.
    11. Nunes, Luis Eduardo & Lima, Marcus Vinicius Andrade de & Davison, Matthew & Leite, André Luis da Silva, 2021. "Switch and defer option in renewable energy projects: Evidences from Brazil," Energy, Elsevier, vol. 231(C).
    12. Bastian-Pinto, Carlos L. & Araujo, Felipe V. de S. & Brandão, Luiz E. & Gomes, Leonardo L., 2021. "Hedging renewable energy investments with Bitcoin mining," Renewable and Sustainable Energy Reviews, Elsevier, vol. 138(C).
    13. Ahmed Al sharif & Ruwen Qin, 2015. "Double-sided price adjustment flexibility with a preemptive right to exercise," Annals of Operations Research, Springer, vol. 226(1), pages 29-50, March.
    14. Trigeorgis, Lenos & Tsekrekos, Andrianos E., 2018. "Real Options in Operations Research: A Review," European Journal of Operational Research, Elsevier, vol. 270(1), pages 1-24.
    15. Nadarajah, Selvaprabu & Secomandi, Nicola, 2023. "A review of the operations literature on real options in energy," European Journal of Operational Research, Elsevier, vol. 309(2), pages 469-487.
    16. Kozlova, Mariia, 2017. "Real option valuation in renewable energy literature: Research focus, trends and design," Renewable and Sustainable Energy Reviews, Elsevier, vol. 80(C), pages 180-196.
    17. Briest, Gordon & Lauven, Lars-Peter & Kupfer, Stefan & Lukas, Elmar, 2022. "Leaving well-worn paths: Reversal of the investment-uncertainty relationship and flexible biogas plant operation," European Journal of Operational Research, Elsevier, vol. 300(3), pages 1162-1176.

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