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EMF WP 13.3: Modeling Energy Technology Choices: Which Finance Tools Are Appropriate?

A variety of tools from modern investment theory have been put forward as holding promise for unraveling energy technology investment decisions that often appear anomalous when analyzed using traditional investment analysis methods. This paper reviews the important insights and assumptions of the investment theories most commonly suggested as candidates for explaining the apparent “energy technology investment paradox.” The applicability of each theory to energy technology investment decisions is considered in light of important aspects of energy technology investment problems, such as sunk costs, uncertainty, and imperfect information. The theories addressed include the Capital Asset Pricing Model, the Arbitrage Pricing Theory, and the theory of irreversible investment. Enhanced net present value methods are also considered. The relevance of the Capital Asset Pricing Model and the Arbitrage Pricing Theory to energy technology decisions, given the special characteristics of energy technology investments, appears limited to the value of their conceptual insights. The theory of irreversible investment and enhanced net present value methods are found to provide more useful frameworks for modeling and analyzing energy technology decisions, as well as providing additional conceptual insights. An appendix illustrates the methods of irreversible investment theory and enhanced net present value analysis by applying them to a simple attic insulation problem.