Project Title: Real Options Analysis In Hydraulic Engineering

Student name: NGUYEN TAN THAI HUNG Supervisor: Prof. Vladan Babovic

INTRODUCTION

In project evaluation, the traditional NPV model has been widely practiced. However, this approach is rigid andincapablein dealingwith uncertainties in complicatedsystemsuchasSingaporewater supply.

This thesisstudies the value of flexibility and the potential fifth tap asa framework for Singaporewater supply system.

REALOPTIONSANALYSISAND MONTECARLOSIMULATIONS

A real option is the right (and not the obligation) to execute a project. It provides the decision maker theability to wait for more information, gaining more flexibility and reducing risks. A real option analysisinvolving Monte Carlosimulation canprovide a more realistic picture than the traditional NPVmodel.

DEMAND MODELING

The population projection is carried out with the PDEProjection software. Projection for individual waterconsumption and industrial demandare basedon historical data. Randomscenariosare then generatedwith anormal distribution around the projected values.

Preliminary analysis showed that based on the current supply capacity, there will be significant shortageshould the imported tap be cut off

Supply and demand spectra

COSTSTRUCTURES"Unit Tariff per Output" structure: no minimum purchaseobligation, highest flexibility, harder to finance andprocure. All risks belongto the concessioncompany."Two-part tariff" : currently adopted. Fixed paymentcovers project capital, partially reducing risks for theconcessioncompany. Variable payments are dependenton production and the concession company still facesmarket risks.

The secondstructure is examinedsince being in used,thefirst structure is tested for its value of flexibility .

SUPPLYMODELINGSingapore water supply system consists of four nationaltaps (catchment, import, NEWater and desalination) withdifferent costs. NEWater and desalination is under DBOOscheme. Each year the required selling price is calculatedbased on the progress of the cost components, availablecapacity and a break-even point . Technicaland energy costfollows two different random walks. To allow for flexibility,eachtap is subject to expansionand reduction

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In this simulationmodel, two values = 0.5and = 0.75will be examined.

)0,365max( CapacityCatchment

capacity storageReservoir capacity Internal -n Consumptio

risk Political

risksecurity Water

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Desalination NEWater LNG-Desalination

Components % % Components Cost ($m)

Energy (variable) 46.90% 23.45% Capital charge 1.65

Investment 29.50% 42.53% Investment 5.67

O & M (fixed) 17.90% 25.80% O & M (fixed) 2.93

Technical

(variable)5.70% 8.22% Variable costs 1.41

Catchment $0.235 / m3

Imported $0.249 / m3

NEWater $0.300 / m3

Desalination $0.780 / m3

COST COMPONENTS

REQUIRED SELLING PRICE CALCULATION

RISKSWater security risk: a risky

year is when the averagedunitcostof supplying a unit volumeof water for a particular year isgreater than $1.00.

Political risk: number of daysSingaporecan survive withoutthe import tap.

RISK PREMIUMTo minimize the cost of supplying water means to use the most of the cheapest, and then the next cheapest one.Taking the cost of imported water as its face value means omitting the potential risks that this tap is cut off. A riskpremium should be incorporated into the cost of imported water when compared with other taps. Risk premiumsranging from $0.00 to $3.50 are examinedin this study.

Quantity

Cost/

Revenue

Max.

capacity Q

Break-even

Variable

cost

Fixed cost

RSP

UNIT PRICES

RESULTSpart vs.

On average, theapproach helps to reduce NPVby 7% becausePUB only bearsthe capital cost when itpurchases some water. On theother hand, for the -part

structure, this payment isfixed so PUB always has to pay.However, the difference is smallbecause the proportion ofinvestment cost is moderate. Inaddition, PUB has the option toexpand when neededin stead ofhaving to pay capital upfront .Therefore, it does not haveexcessive capacity and wastedcapital.The result suggests that thesavings from thedoesnot justify the difficulties infinancing the projects of its type.The dispatch flexibility cannotbalancethe procurement costs.

Risk premium and Economies of scaleWith m < 1, there is a decreasein NPVwhen risk premium increasesto $0.10.With m = 1, NPVfirst increaseswith a lower rate, then faster.NPVis very sensitive with premium < $1.50, and insensitive with premium > $1.50.Increasing risk premium makes local taps more favourable, and increase in local

capacityprovides greater flexibility in adverseevents,therefore NPVdecreases.If risk premium is even higher, the more expensive local tap (desalination in most

cases)stepsin and increasesNPV.

Scenariosin favour of local taps will shift the turning point to the right .Scenariosin favour of imported tap will shift the turning point to the left.If risk premium > $1.50, local taps are alwaysusedup first, henceNPVis not sensitive.

Source: PUB

LNGdesalinationWater security risk is reducedby 10 20% by LNGPolitical risk is reducedby 1 10% by LNGNPV is reduced by 2 to 7 million with LNG. When there is more

restriction in local taps, this can increase to 25 million . Thedifference suggests the maximum allowable cost to put intoresearchto obtain the implementation option.Increasingthe LNGcapacityby 3 times will increasethe savingby

6 to 8 times. This is on .LNGdesalination is proved to be feasible

Effect ofChangingfrom = 0.75 to = 0.5 only decreasesNPVby less than

2%.

Normal circumstance

Limits on local tap, saving increases,

turning point shifts left