Real Options Analysis of Groundwater Extraction and Management with Water Price Uncertainty

doi:10.15266/KEREA.2018.27.4.639

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2018 Vol.27, Issue 4 Preview Page Next Page

Research Paper

Real Options Analysis of Groundwater Extraction and Management with Water Price Uncertainty: Jaehyung Lee*; *Manager, Corporate Customer Group, Industrial Bank of Korea, Seoul, Korea, Main author and Correspondingauthor(e-mail: for385@hanmail.net)

31 December 2018. pp. 639-666

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Abstract

This paper analyses the investment options of groundwater development project under water price uncertainty. The optimal investment threshold price which trigger the investment are calibrated base on monopolistic real options model. Stochastic dynamic model is set to reflect the uncertainty of water price which follows the GBM (Geometric Brownian Motion) process. Our finding from non-cooperative investment decision model is that uncertainty of water price could deter the groundwater investment by considering the existence of option values. For policy markers, it is easy to manage ‘charges for utilization of groundwater’ rather than ‘performance guarantee ratio’ when managing groundwater investment with pricing policy. And it is necessary to make comprehensive and well-designed policies considering the characteristics of regional groundwater reservoir and groundwater developers.

Keywords

Real Option

Groundwater Extraction

Groundwater Management

Water Price Uncertainty

References

Alexandersson, H. “A Simple Stochastic Model of the Precipitation Process,” Journal of Climate and Applied Meteorology, Vol. 24, No. 12, 1985, pp. 1285~1295.10.1175/1520-0450(1985)024<1285:ASSMOT>2.0.CO;2
Bhaduri, A., U. Manna, E. Barbier, and J. Liebe, “Climate Change and Cooperation in Transboundary Water Sharing: An Application of Stochastic Stackelberg Differential Games in Volta River Basin,” Natural Resource Modeling, Vol. 24, No. 4, 2011, pp. 409~444.10.1111/j.1939-7445.2011.00097.x
Bhaduri, A., U. Manna, E. Barbier, and J. Liebe, “Cooperation in Transboundary Water Sharing under Climate Change,” ZEF Discussion Papers on Development Policy, No. 132, Bonn, ZEF Bonn, 2009.
Bhaduri, A., N. Perez, and J. Liebe, “Scope and Sustainability of Cooperation in Transboundary Water Sharing of the Volta River,” ZEF Discussion Papers on Development Policy, No. 124, Bonn, ZEF Bonn, 2008.
Burt, O. R. “Optimal Resource Use Over Time with An Application to Ground Water,” Management Science, Vol. 11, No. 1, 1964, pp. 80~93.10.1287/mnsc.11.1.80
CDP, Accelerating action CDP Global Water Report 2015. Carbon Disclosure Project, 2015.
Cheonan-Si, Cheonan-Si Annual Statistics, Cheonan, Cheonan-Si, 1986~2016.
Cheonan-Si, Cheonan-Si Groundwater Regulation, Cheonan, Cheonan-Si, 2016.
Clark, E. and G. Mondello, “Regulating Natural Monopolies: The Case of Drinking Water in France,” Journal of Contemporary Water Research and Education, Vol. 121, No. 1, 2002, pp. 11.10.1023/A:1008326220811
Clark, E. and G. Mondello, “Resource Management and the Mayor’s Guarantee in French Water Allocation,” Environmental and Resource Economics, Vol. 15, No. 2, 2000, pp. 103~113.
De Condappa, D., J. Barron, K. T. Sat, and M. Sekhar, “Impact Assessment of Agricultural Water Management Interventions in Jaldhaka Watershed,” Project Report, Stockholm, Stockholm Environment Institute, 2011.
Dixit, A. and R. Pindyck, Investment under Uncertainty, Princeton, Princeton University Press, 1994.
Douxchamps, S., A. A. Augustine, and J. Barron, “Evolution of Agricultural Water Management in Rainfed Crop-livestock Systems of the Volta Basin,” CPWF R4D Working Paper Series 04, Colombo, CPWF (CGIAR Challenge Program for Water and Food), 2012.
Evans, W. R. and R. Evans, “Conjunctive Use and Management of Groundwater and Surface Water within Existing Irrigation Commands: the Need for a New focus on an Old Paradigm,” Thematic Paper 2, Sinclair Knight Merz, Groundwater Governance, 2011.
Fisher, A. C. and S. J. Rubio, “Adjusting to climate change: Implications of Increased Variability and Asymmetric Adjustment Costs for Investment in Water Reserves,” Journal of Environmental Economics and Management, Vol. 34, No. 3, 1997, pp. 207~227.10.1006/jeem.1997.1011
Gersonius, B., R. Ashley, A. Pathirana, and C. Zevenbergen, “Climate change Uncertainty: Building Flexibility into Water and Flood Risk Infrastructure.” Climatic Change, Vol. 116, No. 2, 2013, pp. 411~423.10.1007/s10584-012-0494-5
Gisser, M. and D. A. Sanchez, “Competition versus Optimal Control in Groundwater Pumping,” Water Resources Research, Vol. 16, No. 4, 1980, pp. 638~642.10.1029/WR016i004p00638
Han River Water Management Committee. Han River Water Management Fund Statistics, Seoul, Han River Water Management Committee, 2016.
Hartwick, J. M. and N. D. Olewiler, The Economics of Natural Resource Use, Harper & Row, Publishers, Inc., 1986.
IPCC. Climate Change and Water : Technical Paper of the Intergovernmental Panel on Climate Change, Geneva, IPCC, 2010.
Jeju Special Self-Governing Province. Estimation of the Cost of the Groundwater Cost of Jeju Special Self-Governing Province and improvement of the Charging System. Jeju, Jeju Special Self-Governing Province, 2012.
Jeong, I. C. “An Evaluation of the Economic Value of Outsourcing of Water Supply Services Considering Uncertainty of Water Price,” Thesis of the Degree of Master, Seoul, Korea University, 2014.
Kim, S. G. and G. B. Kim, “Preliminary Study on the Comparison of Water Supply Costs between Groundwater and Surface Water,” Journal of the Geological Society of Korea, Vol. 52, No. 4, 2016, pp. 457~464.10.14770/jgsk.2016.52.4.457
Kjaerland, F. “A Real Option Analysis of Investments in Hydropower - The Case of Norway,” Energy Policy, Vol. 35, No. 11, 2007, pp. 5901~5908.10.1016/j.enpol.2007.07.021
KMA. 1981~2010 Climatological Normals of Korea, Seoul, KMA (Korean Meteorological Administration), 2011.
Knapp, K. C. and L. J. Olson, “The Economics of Conjunctive Groundwater Management with Stochastic Surface Supplies,” Journal of Environmental Economics and Management, Vol. 28, No. 3, 1995, pp. 340~356.10.1006/jeem.1995.1022
Laukkanen, M. and P. Koundouri, “Competition versus Coopertion in Groundwater Extraction: A Stochastic Framework with Heteregoneous Agents,” MPRA Paper, No.41910, Muenchen, MPRA (Munich Personal RePEc Archive), 2006.
Le Cam, L. “A Stochastic Description of Precipitation,” Proceedings of the Fourth Berkeley Symposium on Mathematical Statistics and Probability, Vol. 3, 1961.
Lee, J. H. “Stochastic Dynamic Management of Groundwater using Real Options Approach with Uncertainty of Price,” Thesis of the Degree of Doctor, Seoul, Korea University, 2018.
Michailidis, A. and A. Mattas, “Using Real Options Theory to Irrigation Dam Investment Analysis: An Application of Binomial Option Pricing Model,” Water Resources Management, Vol. 21, No. 10, 2007, pp. 1717~1733.10.1007/s11269-006-9122-3
Mikhail, M., A. Fencl, S. Naruchaikusol, and E. Kemp‐Benedict, “Innovation and Diffusion of Sustainable Agricultural Water Resource Management in a Changing Climate: A Case Study in Northeast Thailand,” Project Report, Stockholm, Stockholm Environment Institute, 2010.
Mittal, G. “Real Options Approach to Capacity Planning under Uncertainty,” Thesis of the Degree of Master, Massachusetts, Massachusetts Institute of Technology, 2004.
MOLIT and K-water. National Ground Water Monitoring Network in Korea Annual Report 2016, Gwacheon, MOLIT (Ministry of Land, Infrastructure and Transport) and K-water, 2016a.
MOLIT and K-water. Ground Water Management Plan Report, Gwacheon, MOLIT (Ministry of Land, Infrastructure and Transport) and K-water, 2016b.
MOLTMA. Guidelines for Groundwater Operations, Gwacheon, MOLTMA (Ministry of Land, Transport and Maritime Affairs), 2015.
Moon, Y. I. and Y. I. Cha, “Simulation of Daily Precipitation Data Using Nonhomogeneous Markov Model Ⅰ - Theory,” Journal of The Korean Society of Civil Engineers B, Vol.24, No.5B4, 2004, pp.431~435.
Nasim, S. and S. Helfand, “Optimal Groundwater management in Pakistan’s Indus Water Basin,” International Food Policy Res Institute, Vol.34, 2016.
Park, E. C. and H. J. Park, “Real Options Analysis of Oil and Gas Resource Development for Independent E&P Firms in the North America,” Korea Economic Review, Vol. 30, No. 2, 2014, pp. 349~367.
Park, H. J. “A Real Option Approach to Optimal Use of Natural Resource: Revisiting the Least Cost Principle,” Korea Energy Economics Institute, Vol. 3, No. 1, 2004, pp. 47~69.
Park, H. J. “Real Options and Cost-Benefit Analysis,” Seoul, Option Real, 2017.
Rubio, S. J. and J. P. Castro, “Long-run Groundwater Reserves under Uncertainty,” Investigaciones Económicas, Vol. 20, No. 1, 1996, pp. 71~88.
Richey, A. S., B. F. Thomas, M. H. Lo, J. T. Reager, J. S. Famiglietti, K. Voss, S. Swenson, and M. Rodell, “Quantifying Renewable Groundwater Stress with GRACE,” Water Resources Research, Vol. 51, No. 7, 2015, pp. 5217~5238.10.1002/2015WR01734926900185PMC4744761
Seo, S. T. “A Real Options Approach to the Investment Analysis of Irrigation Systems,” The Korean Journal of Agricultural Economics, Vol. 47, No. 1, 2006, pp. 31~50.
Seo, S. T. et al. “Irrigation Technology Adoption and Its Implication for Water Conservation in the Texas High Plains: A Real Options Approach,” Agricultural Economics, Vol. 38, No. 1, 2008, pp. 47~55.10.1111/j.1574-0862.2007.00280.x
The Bank of Korea. Economic Statistics System (ECOS), Website https://ecos.bok.or.kr/
Todorovic, P. and M. Vujica, “Stochastic Process of Precipitation,” Hydrology Papers, No.35, Colorado, Colorado State University, 1969.
Tsur, Y. “The Economics of Conjunctive Ground and Surface Water Irrigation Systems: Basic Principles and Empirical Evidence from Southern California, Decentralization and Coordination of Water Resource Management,” New York, Springer Science & Business Media, 1997, pp.339~361.
Wang, T. and De R. Neufville, “Building Real Options into Physical Systems with Stochastic Mixed-integer Programming,” Working Paper Series, No.ESD-WP-2005-05, Massachusetts, Massachusetts Institute of Technology, 2005.
Winter, T. C., J. W. Harvery, O. L. Franke, and W. M. Alley, “Ground Water and Surface Water: A Single Resource,” U.S. Geological Survey Circular, No.1139, Denver, U.S. Department of the Interior Bruce Babbitt, Secretary, 1998.
Yu, S. Y., A. J. A. Unger, and T. H. Kim, “Applicability of the Real Option Valuation Method to the Economic Analysis of Water Resources Supply Projects,” Economic and Environmental Geology, Vol. 41, No. 5, 2008, pp. 551~562.

Information

Publisher :Environmental and Resource Economics Review
Publisher(Ko) :자원 · 환경경제연구
Journal Title :자원·환경경제연구
Journal Title(Ko) :Environmental and Resource Economics Review
Volume : 27
No :4
Pages :639-666
DOI :https://doi.org/10.15266/KEREA.2018.27.4.639

[1] Alexandersson, H. “A Simple Stochastic Model of the Precipitation Process,” Journal of Climate and Applied Meteorology, Vol. 24, No. 12, 1985, pp. 1285~1295.10.1175/1520-0450(1985)024<1285:ASSMOT>2.0.CO;2

[2] Bhaduri, A., U. Manna, E. Barbier, and J. Liebe, “Climate Change and Cooperation in Transboundary Water Sharing: An Application of Stochastic Stackelberg Differential Games in Volta River Basin,” Natural Resource Modeling, Vol. 24, No. 4, 2011, pp. 409~444.10.1111/j.1939-7445.2011.00097.x

[3] Bhaduri, A., U. Manna, E. Barbier, and J. Liebe, “Cooperation in Transboundary Water Sharing under Climate Change,” ZEF Discussion Papers on Development Policy, No. 132, Bonn, ZEF Bonn, 2009.

[4] Bhaduri, A., N. Perez, and J. Liebe, “Scope and Sustainability of Cooperation in Transboundary Water Sharing of the Volta River,” ZEF Discussion Papers on Development Policy, No. 124, Bonn, ZEF Bonn, 2008.

[5] Burt, O. R. “Optimal Resource Use Over Time with An Application to Ground Water,” Management Science, Vol. 11, No. 1, 1964, pp. 80~93.10.1287/mnsc.11.1.80

[6] CDP, Accelerating action CDP Global Water Report 2015. Carbon Disclosure Project, 2015.

[7] Cheonan-Si, Cheonan-Si Annual Statistics, Cheonan, Cheonan-Si, 1986~2016.

[8] Cheonan-Si, Cheonan-Si Groundwater Regulation, Cheonan, Cheonan-Si, 2016.

[9] Clark, E. and G. Mondello, “Regulating Natural Monopolies: The Case of Drinking Water in France,” Journal of Contemporary Water Research and Education, Vol. 121, No. 1, 2002, pp. 11.10.1023/A:1008326220811

[10] Clark, E. and G. Mondello, “Resource Management and the Mayor’s Guarantee in French Water Allocation,” Environmental and Resource Economics, Vol. 15, No. 2, 2000, pp. 103~113.

[11] De Condappa, D., J. Barron, K. T. Sat, and M. Sekhar, “Impact Assessment of Agricultural Water Management Interventions in Jaldhaka Watershed,” Project Report, Stockholm, Stockholm Environment Institute, 2011.

[12] Dixit, A. and R. Pindyck, Investment under Uncertainty, Princeton, Princeton University Press, 1994.

[13] Douxchamps, S., A. A. Augustine, and J. Barron, “Evolution of Agricultural Water Management in Rainfed Crop-livestock Systems of the Volta Basin,” CPWF R4D Working Paper Series 04, Colombo, CPWF (CGIAR Challenge Program for Water and Food), 2012.

[14] Evans, W. R. and R. Evans, “Conjunctive Use and Management of Groundwater and Surface Water within Existing Irrigation Commands: the Need for a New focus on an Old Paradigm,” Thematic Paper 2, Sinclair Knight Merz, Groundwater Governance, 2011.

[15] Fisher, A. C. and S. J. Rubio, “Adjusting to climate change: Implications of Increased Variability and Asymmetric Adjustment Costs for Investment in Water Reserves,” Journal of Environmental Economics and Management, Vol. 34, No. 3, 1997, pp. 207~227.10.1006/jeem.1997.1011

[16] Gersonius, B., R. Ashley, A. Pathirana, and C. Zevenbergen, “Climate change Uncertainty: Building Flexibility into Water and Flood Risk Infrastructure.” Climatic Change, Vol. 116, No. 2, 2013, pp. 411~423.10.1007/s10584-012-0494-5

[17] Gisser, M. and D. A. Sanchez, “Competition versus Optimal Control in Groundwater Pumping,” Water Resources Research, Vol. 16, No. 4, 1980, pp. 638~642.10.1029/WR016i004p00638

[18] Han River Water Management Committee. Han River Water Management Fund Statistics, Seoul, Han River Water Management Committee, 2016.

[19] Hartwick, J. M. and N. D. Olewiler, The Economics of Natural Resource Use, Harper & Row, Publishers, Inc., 1986.

[20] IPCC. Climate Change and Water : Technical Paper of the Intergovernmental Panel on Climate Change, Geneva, IPCC, 2010.

[21] Jeju Special Self-Governing Province. Estimation of the Cost of the Groundwater Cost of Jeju Special Self-Governing Province and improvement of the Charging System. Jeju, Jeju Special Self-Governing Province, 2012.

[22] Jeong, I. C. “An Evaluation of the Economic Value of Outsourcing of Water Supply Services Considering Uncertainty of Water Price,” Thesis of the Degree of Master, Seoul, Korea University, 2014.

[23] Kim, S. G. and G. B. Kim, “Preliminary Study on the Comparison of Water Supply Costs between Groundwater and Surface Water,” Journal of the Geological Society of Korea, Vol. 52, No. 4, 2016, pp. 457~464.10.14770/jgsk.2016.52.4.457

[24] Kjaerland, F. “A Real Option Analysis of Investments in Hydropower - The Case of Norway,” Energy Policy, Vol. 35, No. 11, 2007, pp. 5901~5908.10.1016/j.enpol.2007.07.021

[25] KMA. 1981~2010 Climatological Normals of Korea, Seoul, KMA (Korean Meteorological Administration), 2011.

[26] Knapp, K. C. and L. J. Olson, “The Economics of Conjunctive Groundwater Management with Stochastic Surface Supplies,” Journal of Environmental Economics and Management, Vol. 28, No. 3, 1995, pp. 340~356.10.1006/jeem.1995.1022

[27] Laukkanen, M. and P. Koundouri, “Competition versus Coopertion in Groundwater Extraction: A Stochastic Framework with Heteregoneous Agents,” MPRA Paper, No.41910, Muenchen, MPRA (Munich Personal RePEc Archive), 2006.

[28] Le Cam, L. “A Stochastic Description of Precipitation,” Proceedings of the Fourth Berkeley Symposium on Mathematical Statistics and Probability, Vol. 3, 1961.

[29] Lee, J. H. “Stochastic Dynamic Management of Groundwater using Real Options Approach with Uncertainty of Price,” Thesis of the Degree of Doctor, Seoul, Korea University, 2018.

[30] Michailidis, A. and A. Mattas, “Using Real Options Theory to Irrigation Dam Investment Analysis: An Application of Binomial Option Pricing Model,” Water Resources Management, Vol. 21, No. 10, 2007, pp. 1717~1733.10.1007/s11269-006-9122-3

[31] Mikhail, M., A. Fencl, S. Naruchaikusol, and E. Kemp‐Benedict, “Innovation and Diffusion of Sustainable Agricultural Water Resource Management in a Changing Climate: A Case Study in Northeast Thailand,” Project Report, Stockholm, Stockholm Environment Institute, 2010.

[32] Mittal, G. “Real Options Approach to Capacity Planning under Uncertainty,” Thesis of the Degree of Master, Massachusetts, Massachusetts Institute of Technology, 2004.

[33] MOLIT and K-water. National Ground Water Monitoring Network in Korea Annual Report 2016, Gwacheon, MOLIT (Ministry of Land, Infrastructure and Transport) and K-water, 2016a.

[34] MOLIT and K-water. Ground Water Management Plan Report, Gwacheon, MOLIT (Ministry of Land, Infrastructure and Transport) and K-water, 2016b.

[35] MOLTMA. Guidelines for Groundwater Operations, Gwacheon, MOLTMA (Ministry of Land, Transport and Maritime Affairs), 2015.

[36] Moon, Y. I. and Y. I. Cha, “Simulation of Daily Precipitation Data Using Nonhomogeneous Markov Model Ⅰ - Theory,” Journal of The Korean Society of Civil Engineers B, Vol.24, No.5B4, 2004, pp.431~435.

[37] Nasim, S. and S. Helfand, “Optimal Groundwater management in Pakistan’s Indus Water Basin,” International Food Policy Res Institute, Vol.34, 2016.

[38] Park, E. C. and H. J. Park, “Real Options Analysis of Oil and Gas Resource Development for Independent E&P Firms in the North America,” Korea Economic Review, Vol. 30, No. 2, 2014, pp. 349~367.

[39] Park, H. J. “A Real Option Approach to Optimal Use of Natural Resource: Revisiting the Least Cost Principle,” Korea Energy Economics Institute, Vol. 3, No. 1, 2004, pp. 47~69.

[40] Park, H. J. “Real Options and Cost-Benefit Analysis,” Seoul, Option Real, 2017.

[41] Rubio, S. J. and J. P. Castro, “Long-run Groundwater Reserves under Uncertainty,” Investigaciones Económicas, Vol. 20, No. 1, 1996, pp. 71~88.

[42] Richey, A. S., B. F. Thomas, M. H. Lo, J. T. Reager, J. S. Famiglietti, K. Voss, S. Swenson, and M. Rodell, “Quantifying Renewable Groundwater Stress with GRACE,” Water Resources Research, Vol. 51, No. 7, 2015, pp. 5217~5238.10.1002/2015WR01734926900185PMC4744761

[43] Seo, S. T. “A Real Options Approach to the Investment Analysis of Irrigation Systems,” The Korean Journal of Agricultural Economics, Vol. 47, No. 1, 2006, pp. 31~50.

[44] Seo, S. T. et al. “Irrigation Technology Adoption and Its Implication for Water Conservation in the Texas High Plains: A Real Options Approach,” Agricultural Economics, Vol. 38, No. 1, 2008, pp. 47~55.10.1111/j.1574-0862.2007.00280.x

[45] The Bank of Korea. Economic Statistics System (ECOS), Website https://ecos.bok.or.kr/

[46] Todorovic, P. and M. Vujica, “Stochastic Process of Precipitation,” Hydrology Papers, No.35, Colorado, Colorado State University, 1969.

[47] Tsur, Y. “The Economics of Conjunctive Ground and Surface Water Irrigation Systems: Basic Principles and Empirical Evidence from Southern California, Decentralization and Coordination of Water Resource Management,” New York, Springer Science & Business Media, 1997, pp.339~361.

[48] Wang, T. and De R. Neufville, “Building Real Options into Physical Systems with Stochastic Mixed-integer Programming,” Working Paper Series, No.ESD-WP-2005-05, Massachusetts, Massachusetts Institute of Technology, 2005.

[49] Winter, T. C., J. W. Harvery, O. L. Franke, and W. M. Alley, “Ground Water and Surface Water: A Single Resource,” U.S. Geological Survey Circular, No.1139, Denver, U.S. Department of the Interior Bruce Babbitt, Secretary, 1998.

[50] Yu, S. Y., A. J. A. Unger, and T. H. Kim, “Applicability of the Real Option Valuation Method to the Economic Analysis of Water Resources Supply Projects,” Economic and Environmental Geology, Vol. 41, No. 5, 2008, pp. 551~562.

자원·환경경제연구 ISSN:1229-9146(Print) Environmental and Resource Economics Review

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