Risks and opportunities related to environmental transition are usually evaluated through the use of scenarios, produced and maintained by international bodies such as the International Energy Agency. This approach assumes perfect knowledge of the scenario by the agent, but in reality, scenario uncertainty is an important obstacle for making optimal investment or divestment decisions. In this paper, we develop a real-options approach to evaluate energy assets and potential investment projects under dynamic energy transition scenario uncertainty. We use off-the-shelf Integrated Assessment Model (IAM) scenarios and assume that the economic agent acquires the information about the scenario progressively by observing a signal, such as the carbon price or the greenhouse gas emissions. The problem of valuing an investment is formulated as an American option pricing problem, where the optimal exercise time corresponds to the time of entering into a potential investment project or the time of selling a potentially stranded asset. To illustrate our approach, we apply representative scenarios from the scenario database of the Network for Greening the Financial System to the examples of a coal-fired power plant without Carbon Capture and Storage (CCS) and potential investment into a biomass power plant with CCS.

The preprint is available here.