Theoretical bases of a method of real options in the process of evaluating the efficiency of energy sector projects

The theory of real options is one of the methods of investment risk management considering both negative and positive outcomes of risk factors. Therefore it is obviously necessary to consider the essence of this theory, its applicability and role in the process of risk management of the projects.

Practically all dynamic methods of investment risk management are based on possibility of administrative maneuver - refusal of the project or of the part of its purposes, revision of the idea of the project, possibility of sharing, influence strengthening, decrease in influence - so the dynamic model of the project reflectes ability of the manager to influence the project concerning risk factors.

Also it should be noticed that the static model of the project is the cornerstone of static methods of the management. These methods are directed mainly on settlement of failures, disregarding a positive side of risk decisions, the developer projects approved in the course of realization. Static character allows to remove the uncertainty inherent in all investment activity and caused by a temporary gap between the resources invested in the project and its result. Also static model of the project doesn't consider a factor of administrative flexibility -possibility of the manager to correct and change project parameters in process of its realization taking into account the incoming information.

The expected positive consequences and factors of administrative flexibility are considered within the modern theory of risk management and assessment of the investment projects. In this case the method of real options based on adaptability of investment projects to environment should be taken into consideration.

The definition of a financial option presented in the monumental work "Investments" of W.F. Sharpe should be considered as the following: "The financial option is the contract between two persons according to which one person grants to another person the right to buy a certain asset at a determined price within a certain period of time or grants the right to sell a certain asset at a determined price within a certain period of time. The person who receives the option is called the buyer of the option and has to pay for this right. The person who sells the option and responds to the decision of the buyer, is called the seller of the option" [Sharpe W., 2009].

The term "real option" is based on the statement that an asset is not only securities, but also real objects - capacities, resources, works of art, investment projects, other. In my opinion, the analogy between financial and real options isn't admissible taking into account considerable distinctions between these concepts.

First, the financial option is the contract between the parties in the competitive and liquid market (options, and, above all — a basic asset) whereas real options are virtual concept: they exist usually only in the manager's head, and the second player is environment, therefore, real options can't be resold to other persons.

Secondly, the real option is directed to maximize value, unlike the financial option acting as means of hedging the risk. The nature of financial and real options is various therefore direct transfer of the theory of financial options for real options isn't correct.

Thirdly, the holder of a real option plays an active role in generation of cash flows of a basic asset (the project, business) by adoption the relevant financial decisions while the holder of a financial option is the passive participant of the generation process of cash flows of a financial asset as its cost is generated by the market. The holder of a financial option has potential rights for possession or sale of an asset while the decisions of the manager or the owner of the project are capable to create options [Lukasiewicz I.Ya., 2012].

The definitions of the term "real option" founded in the literature are stated in table 1.1.

Table 1.1 Definitions of the term “real option”

Real option is the right or opportunity to make the flexible decisions or actions allowing to increase the cost (value) of assets or to reduce losses

It should be noted that the treatment offered by Limitovsky M. A. contradicts the above-stated differences of financial and real options.

From table 1.1 it is possible to mark out the following main properties of real options:

• 1.    Possibility of choice - to carry out an option or not (since it is the right, but not a duty);

• 2.    Possibility of accounting the uncertainty;

• 3.    Possibility of adoption of flexible decisions in conditions of constantly changing environment;

• 4.    Special-purpose character of administrative actions.

Real options are administrative possibility of adoption of flexible decisions in conditions of dynamic environment allowing to increase the cost (value) of assets or to reduce losses. Despite various nature of an origin of real and financial options, they use the following general terminology:

• •      the "call" option is the right, but not a duty to buy a certain asset at

the established buying price;

• •      the "put" option is the right, but not a duty to sell a certain asset at the

established realization price;

• •     the American option can be carried out in time or according to the

term of its repayment;

• •     the European option can be carried out only in an advanced

stipulated date.

In my opinion, the method of real options allows:

• -     to expand tools of methods of investments assessment;

• -     to consider uncertainty in the course of making decision on

implementation of the project;

• -     to estimate quantitatively administrative flexibility as additional

possibility of the developer project;

• -     to develop possible strategy of risk management of the project;

• -     to avoid the underestimation of the project which is carried out on the

basis of traditional methods of the analysis.

In application of the theory of real options there are some restrictions. As A. Damodaran, the expert in the field of financial investments, notes the value of an asset can be determined as the specified value of the cash flows falling on this asset.

However there is an exception carring out two specific characteristics:

• 1)    The value of asset is derivative of the value of other assets;

• 2)    The cash flows created by this asset are caused by approach of certain events.

In case of existence of these characteristics, it is necessary to address to a method of real options [Damodaran A., 2012]. Also in literature there are other conditions of expediency of application of the theory of real options [Selin V.P., 2011]:

• -    The level of uncertainty of the project is high, however the part of it can be resolved at receipt of new information in future;

• -    Management has an opportunity to carry out administrative influence - to change something in case of the new information.

Scientific researches of real options are completely based on the idea that flexibility has an ability to reduce not only negative consequences, but also to use favorable opportunities at implementation of the project.

As it has been noted above, in the theory of real options the basic category is adaptability, which main roles are the following:

• -    The reacting role - the owner of an option seeking to maximize the income makes decisions on the basis of external factors;

• -    An initiative role - possibility of managers to increase the option cost of the investment project before execution of the option.

In the model of assessment of real options the cost of adaptability and uncertainty generating investment risks of the project is considered. Undoubtedly, the quantitative assessment of these factors is very significant in risk -management. In the classical theory the assessment of only negative characteristics of risk are investigated, taking into consideration only possibility of losses.

Real options influence adoption of administrative decisions on an assessment of investment projects due to active risk management, being a basis of economic growth in activity of any developer. Using various methods of the analysis of investment projects (in particular, a method of scenarios and imitating modeling) it is possible to predict probability of positive or negative consequences in application of the real options theory.

The analysis of the specialized literature devoted to real options revealed the following classification of options:

• 1.    Depending on a basic asset

• 2.    Depending on the part of balance

• 3.    Depending on uncertainty type

• 4.    Depending on administrative actions of the manager

• 5.    Depending on risk influence

Lets consider this classification of real options given above in details. The classification adapted for the theory of financial management depending on a basic asset is presented in table 1.2.

Table 1.2

Classification of real options by the form asset

Active	Possible real options
The investment opportunity	- Reduction of the volume of investment.
Production	-    Expansion of production by means of implementation of additional investments; -    Work with different resources or diversification of a product line.
Car/equipment	-    Transfer to the idle time mode; -    Sale at residual cost
Contract	- Conditions of the termination (renewal) of the contract
Technological patent	- Sale, transfer of the license or leaving the rights

The following classification of options is based on the balance. It is given in Limitovsky M. A. work in detail and is based on division of real options on two large groups - assets (investment decisions) and liabilities (financial decisions) [Limitovsky M. A., 2011]. Options in assets are connected with the made investment decisions and answer a question of an investment advantage in the project. Options in liabilities, namely options based on obligations and own capital, are connected with decisions in the field of sources of financing the realized investment projects.

In my opinion, classification of options is a technical problem. The option depending on several types of uncertainty is called iridescent. Modeling of iridescent options is technically a rather complex challenge. Theoretically all options are iridescent, however it is expedient to allocate the main type of uncertainty influencing the solved researcher's task.

As the real options theory assumes administrative impact on the project - the classification given by such foreign authors as T. Copeland, T.Koller, J. Murin [T. Copeland, T. Koller, J. Murin, 2007], and also domestic ones - Limitovsky M. A. [Limitovsky M. A., 2011] and Bukhvalov A.V. [Bukhvalov, A.V., 2013], is based on possibility of the parameters variation of the specific investment project.

Table 1.3

Classification of real options depending on their influence on the project risks

[R. Brealey, S. Myers., 2009]

The real options reducing negative consequences of risk events	The real options increasing positive opportunities of risk events
On reduction of the project	On reshaping (diversification) of the project

On an exit from the project / early end of the project	On expansion/development of the project
On a delay of the beginning of the project (waiting)	On possibility of strengthening business
On a temporary suspension of the project	On the implementation stage of the project

In my opinion, project managers have to mean constantly the classification given in table 1.3. The real options increasing favorable opportunities allow managers to increase the NPV of the project by means of the following transformations: to manage the project depending on the increased demand, to expand the project by means of new investments and additional construction.