The Value of Uncertainty: A Quantitative Study on How Volatility in the Electricity Market Affects Onshore Wind Park Investments

Abstract

As the world grapples with the challenges of climate change and sustainable development, renewable electricity sources are in high demand. Further, the ongoing energy crisis has highlighted the need for self-sufficient production e.g., as natural gas restrictions have affected electricity supply, subsequently leading to large price fluctuations. Given the novelty of the situation, this thesis aims to investigate the investment prospects of a Danish onshore wind park in an increasingly volatile electricity market. When gathering investment capital, different strategies to guarantee future income can be pursued, which inherently entails risk. Therefore, hedging using futures contracts is explored to give insights into the increased risk landscape and specifically the liquidity risk stemming from margin requirements which can lead to dire consequences for the investor.

To provide insights to help investors make informed decisions, the research follows a quantitative approach conducting two valuations, 1) discounted cash flow model (DCF), and 2) real options valuation. The two valuations methods are found to offer complimentary insights as the DCF is widely used in practice and recognizable to managers, while the real options valuation captures more value from the flexibility and agility of decision-making. The DCF yielded a negative net present value of EUR -4,92m, whereas the real options valuation generated a return of EUR 23,94m, illustrating the added value from including volatility in the valuation, and thereby highlighting its practical potential. Additionally, Value at Risk calculations are performed from 2018 to 2022 demonstrating a substantial increase of the overall risks in the examined period. Following the same trend, the exposure value of trading with electricity in the forward market has increased close to 500% as daily price changes have rapidly grown causing large margin requirements and liquidity stress. Threatening firms with bankruptcy if they do not have adequate cash quickly available. This elucidates a heightened need for caution wherein investors should adjust their hedging ratios and exposures accordingly. The findings indicate a tradeoff as the volatility positively affects the return on investment, while negatively impacting the risks facing the investor. It is therefore concluded that investors must consider how hedging strategies affect valuations when assessing the investment prospects of an onshore wind park.