Hydrological risk integration in a hydro power plant real options analysis

Traditional valuation methods such as net present value, internal rate of return or payback period perform investment assessment based on the average generation of a hydro plant, ignoring investment irreversibility, uncertainty and management flexibility. Among all the sources of volatility, this study presents the impact on a hydro power plant investment of two different hydrological patterns based on the historical inflows of Douro and Guadiana rivers. For a hydro power plant without a reservoir and pumping facilities, inflows are critical for both generation and for revenues creation. This work aims to apply the Real Options Approach (ROA) based on the binomial tree method developed by Cox, Ross and Rubinstein [1] on the economic evaluation of a hydro power plant investment that the investor can defer for a limited period, taking into account the hydrological risk impact.