Uncertainty, Irreversibility, And Investment In Second-Generation Biofuels

The present study formalizes and quantifies the importance of uncertainty for investment in a corn-stover based cellulosic biofuel plant. Using a real options model we recover prices of gasoline that would trigger entry into the market and calculate the portion of that entry trigger price required to cover cost and the portion that corresponds to risk premium. We then discuss the effect of managerial flexibility on the entry risk premium and the prices of gasoline that would trigger mothballing, reactivation, and exit. Results show that the risk premium required by plants to enter the second-generation biofuel market is likely to be substantial. The analysis also reveals that a break-even approach (which ignores the portion of entry price composed of risk premium) would significantly underestimate the gasoline entry trigger price and the magnitude of that underestimation increases as both volatility and mean of gasoline prices increase. Results also uncover a great deal of hysteresis (i.e. a range of gasoline prices for which there is neither entry nor exit in the market) in entry/exit behavior by plants. Hysteresis increases as gasoline prices become more volatile. Hysteresis suggests that, at the industry level, positive (negative) demand shocks will have a significant impact on prices (production) and a limited impact on production (prices). In combination all of these results suggest that policies supporting second generation biofuels may have fallen short of their targets because of their failure to alleviate uncertainty.