The poverty of cost models, the wealth of real options

Abstract

The attempts to estimate forward looking costs worldwide are based on cost models whose foundation is traditionally applied discounted cash flow analysis — exactly the method that the real options methodology has shown can give terribly wrong results. However, these cost models are ideal vehicles to adapt to the real options methodology. This paper develops a stylized cost model to quantify several deficits associated with the cost models in use today. Even without the application of real options methodology, the stylized results show a significant difference between the revenue requirements model and a traditional discounted present value model. With the application of real options techniques, the differences become much greater.

The implications are significant. Policymakers who attempt to use proxy cost models to emulate the market behavior of firms in competition without considering real options are acting unwisely. Policies that deal with costs cannot be effective without a fundamental understanding of the implications of real options theory.

The author would like to thank Larry Cole, Wynne Cougill, Barbara R. Miller, and Eli Noam for their useful comments and suggestions. The partial support of Curtin University of Technology, Perth, Australia, is also gratefully acknowledged. The usual disclaimer applies.