Academic journal article Journal of Agricultural and Applied Economics

A New Look at the Economic Evaluation of Wind Energy as an Alternative to Electric and Natural Gas-Powered Irrigation

Academic journal article Journal of Agricultural and Applied Economics

A New Look at the Economic Evaluation of Wind Energy as an Alternative to Electric and Natural Gas-Powered Irrigation

Article excerpt

An extension of the Guerrero et al. (2010) net present value (NPV) analysis using real options analysis (ROA) is offered to improve machinery replacement decisions. Specifically, the feasibilities of replacing natural gas irrigation systems with either electric or hybrid (electric/wind) systems are evaluated. Results indicate NPV and ROA criteria can yield opposite decisions depending on the stochastic nature of the parameters, reversibility of the investment, and flexibility of investment timing. For policy, NPV results indicate that replacing natural gas with a hybrid is on the cusp of being optimal. However, ROA indicates this NPV implication may not hold.

Key Words: electricity, irrigation, natural gas, wind energy

JEL Classifications: Q12, Q20, Q42

(ProQuest: ... denotes formulae omitted.)

Wind as an alternative to natural gas is a renewable energy source for powering irrigation wells, which enhances energy security and has the potential to mitigate the impact of volatile natural gas prices. From 1997 to 2011, natural gas prices have ranged from $3.12 to $9.65 per thousand cubic feet (Mcf) with a mean of 5.71 and a standard deviation of 2.00 (EIA, 2012). Guerrero et al. (2010) use standard net present value (NPV) analysis to determine the feasibility of replacing natural gas irrigation systems with either electric or hybrid (electric/wind) systems. However, such replacement comes with a relatively large sunk cost in which once the option to replace is exercised, the replacement cost is irreversible. This irreversibility in conjunction with the stochastic nature of natural gas prices limits the ability of NPV analysis to determine the appropriate prices and costs to exercise the replacement option. NPV analysis assumes the underlying conditions remain stationary and definite in the future, but this assumption can be costly in the context of stochastic prices. If the replacement option is exercised and natural gas prices decline, it may have been optimal instead to delay the replacement. This is particularly relevant with the recent decline in natural gas prices from abundant supplies generated by hydraulic fracturing extraction methods.

An alternative to the NPV analysis is real options analysis (ROA), which accounts for stochastic prices, replacement irreversibility, and the possibility of delaying the replacement. ROA incorporates the existence of future cash flow uncertainty into capital budgeting decisions. Past applications of ROA include crop variety selection (Richards and Green, 2003), grower investment behavior (Elmer et al., 2001), and fuel choice (Tareen, Wetzstein, and Duffield, 2000). In terms of ROA for irrigation, Carey and Zilberman (2002) look at its effect on adoption delay, McClintock (2010) is concerned with evaporation mitigation systems, Michailidis and Mattas (2007) investigate dam investment, and Seo et al. (2008) consider efficient irrigation systems. Mezey and Conrad (2010) provide a general review of ROA in resource economics and in particular water.

The objective of this study is to illustrate through re-evaluating the Guerrero et al. (2010) study the advantages of using ROA in agricultural production decisions when facing highly uncertain input energy markets specifically and any input price uncertainty in general. In particular, ROA has a natural advantage over NPV analysis in cases in which investment costs and returns are highly uncertain and involve substantial irreversible initial costs. This is generally characteristic of alternative energy investments and in particular wind energy investments.

ROA is not a new investment aid for evaluating wind energy projects. In terms of large wind energy farms, Venetsanos, Angelopoulou, and Tsoutsos (2002) used ROA for evaluating wind energy systems and then designed an outline to evaluate renewable energy power projects by considering underlying uncertainties that are inherent to energy production. Their research was followed by Luna, Assuad, and Dyner (2003), Dykes and Neufville (2008), Munoz et al. …

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