Uncertainty, Irreversibility, and Investment in Second-Generation Biofuels

The present study quantifies the importance of price risk and irreversibility for investment in a corn stover-based cellulosic biofuel plant. Using a real-option model, we recover prices of gasoline that would trigger entry into the market and compare it to breakeven price. Our analysis shows that the price premium (above breakeven) required by investors to enter the market due to risk is substantial. Managerial flexibility (embedded in the option of mothballing and reactivating the plant) does not sensibly reduce the entry premium. Results also show that price volatility may greatly reduce plants' responsiveness to gasoline prices and decrease supply elasticity. In combination, 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.