Uncertainty, Irreversibility, and Investment in Second-Generation Biofuels

The present study formalizes and quantifies the importance of uncertainty, irreversibility, and managerial flexibility for investment in a corn-stover based cellulosic biofuel plant. Using a real options model, we recover prices of gasoline that would trigger entry into the market and compare it to breakeven entry price (long run average cost). Our analysis shows that the price premium (above breakeven) likely to be required by investors to enter the market due to the uncertain and irreversible nature of investment is substantial. Managerial flexibility (embedded by the option of mothballing and reactivating the plant) does not sensibly reduce the entry premium. Results also suggest that price volatility may greatly increase hysteresis (i.e. a range of gasoline prices for which there is neither entry nor exit in the market) in firm behavior and decrease supply elasticity. In combination all of these results suggest that, 1) policies supporting second generation biofuels may have fell short of their targets because of their failure to alleviate price uncertainty, and 2) the use of price-based instruments such as reverse auctions, either in isolation or in combination with mandates, may be warranted