The Push for Renewables in India: A Real Options Approach

The Indian government had recently announced plans to add 175 GW of renewable energy capacity to the electricity sector in India by 2022. This comprises capacities of 100 GW of Solar, 60 GW of Wind and 15 GW from other renewable sources such as Small Hydro, Biomass and Urban and Industrial Waste to Energy. India has one of the highest solar radiations in the world and the western states of Gujarat and Rajasthan could lead the way for solar installations in India. On the other hand, in various parts of India, low to medium scale wind farms and wind energy production is on the rise. Suzlon Energy (an Indian manufacturing entity) is one of the leading manufacturers of windmill blades and has been responsible for installing low cost windmills in parts in India. India also faces two pertinent problems: about 240 million (20% of population) do not have access to electricity and for the fiscal year 2014-15, about 75.61% of electricity was generated from coal and only about 5.31% from wind and solar. Moreover, the share of domestic coal was 65.33% and that of imported coal was 10.28%. The stated objective of the Indian government has been to achieve sustained economic growth while meeting energy requirements of the population at affordable prices and extending electricity access for all. On the other hand, because of volatile coal prices, issues for energy security and a growing coal import bill (it was US $14.5 bn in 2013-14), the government wants to stop thermal coal imports within the next five years while increasing domestic coal production to about 1000 million tons from present levels of a little more than 600 million tons per year. Apart from stated energy-saving measures such as increasing energy efficiency and thermal efficiency when building new coal-fired plants and switching to LED lights in streets and homes, one of the best ways forward is to comply as much as possible with the target of 160 GW of new solar and wind installations. With an assumed growth rate of 6% per year and the current trend in solar and wind installations, we expect total installations to be about 111.24 GW by 2025 which would entail the share of solar and wind to increase from 5.31% at present to 11.08% and that of coal to fall to 69.84%. Finally, we include pollution to take account of the fact of pollution from coal-burning for electricity production. World Health Organization (WHO) reports that of the 20 most polluted cities in the world, 13 are in India with Delhi being the most polluted. One of the major reasons for Delhi´s dirty air is old and inefficient coal-fired power plants running way beyond their useful lives. The objective of this paper is to use volatile world coal prices as a source of uncertainty and stochasticity to see if India should make more investments in wind and solar such as to replace imported coal completely as a source of electricity production. We expect to see that higher world coal prices should force India to make renewable energy investments at a faster pace. A longer term objective could also be about one-fifth of electricity generated from wind and solar and the share of coal being about 60%. We use a real options approach as in Detert and Kotani (2013) to analyze this energy switching problem. It is a tool widely used in computational economics and finance to study problems of making a one-time investment when waiting to make the investment implies a postive value. The specific problem in our paper is to replace imported coal (and a longer term objective of replacing some of domestic coal) with wind and solar to generate electricity. The problem is posed as an optimal stopping problem under stochastic coal prices such that the attractiveness of using the current mix of coal and wind and solar (to produce electricity) is compared with the value of using more and wind and solar each period. Working backward from the terminal to the initial period, this process represents the ability of the social planner to re-evaluate the prospect of making an investment each year. The optimal stopping problem is posed as solving a Bellman Equation backward as in Dixit and Pindyck (1994) where waiting to exercise the option gives an option value: in our context, the problem is whether to continue (with the current mix) for another period or make an investment such as to switch to a new regime. The answer based on the stochastic nature of coal prices would be a trigger price, given the parameters of the model. This trigger price would induce the social planner to make the investment (or exercise the option). We use Quarterly data from 1980 to 2016 for global coal price of coal per ton (nominal US dollars) for benchmark Australian coal export prices. Indonesia and Australia are the biggest exporters of coal whereas China and India are the largest importers (IEA, Key World Energy Statistics, 2015). Our preliminary results suggest that including externalities from coal-fired plants for power generation, the trigger price for switching today to a mix with greater use of wind and solar is US $ 63.67 per ton of coal. This result is parallel to the result of Detert and Kotani (2013), where the value of a now-or-never decision for switching exceeds that of having more decision opportunities or periods. If we do not include externalities from coal-fired plants, we get the result that the value of waiting exceeds that of a now-or-never decision and the social planner would not make the investment today and switch to greater use of wind and solar.