Financial Valuation for Commercial Energy Retrofits under Private Risks

Investments in commercial energy retrofits are exposed to unique types of risks that can be placed into two categories of risk: market risks (risks because of volatile market conditions) and private risks (risks because of volatile energy consumptions). By identifying such risks as a major contributor to the financial barrier, most studies to date have focused on market risks, yet these studies lacked consideration of the effect of private risks. In response, this paper aims to present a real options valuation (ROV) that aids in determining the financial effects of private risks on commercial energy retrofit investments. In particular, the study focuses on the valuation of phased investments in a large building portfolio under private risks that contribute to the option to defer (wait and see). The ROV adapts the binomial lattice method based on the level of volatility that is estimated using Monte Carlo simulation. The ROV results of the one-phase strategy are compared to those of the two-phase strategy to quantify the benefit of the increased managerial flexibility of the phased investments. The valuation presented in this paper is expected to help building owners and investors make better informed decisions in commercial energy retrofits and, as a result, effectively overcome the financial barrier.