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BACHELOR OF ENGINEERINGS DISSERTATION

Project Title: Real Options Analysis In Hydraulic Engineering


Student name:

NGUYEN TAN THAI HUNG

Supervisor: Prof. Vladan Babovic

INTRODUCTION
FOUR TAPS
In project evaluation, the traditional NPV model has been widely practiced. However, this approach is rigid and UNIT PRICES
incapable in dealing with uncertainties in complicated system such as Singapore water supply.
This thesis studies the value of flexibility and the potential fifth tap as a framework for Singapore water supply system.
REAL OPTIONS ANALYSIS AND MONTE CARLO SIMULATIONS
A real option is the right (and not the obligation) to execute a project. It provides the decision maker the
ability to wait for more information, gaining more flexibility and reducing risks. A real option analysis
involving Monte Carlo simulation can provide a more realistic picture than the traditional NPV model.
DEMAND MODELING
The population projection is carried out with the PDE Projection software. Projection for individual water
consumption and industrial demand are based on historical data. Random scenarios are then generated with a
normal distribution around the projected values.
Preliminary analysis showed that based on the current supply capacity, there will be significant shortage
should the imported tap be cut off
SUPPLY MODELING
Singapore water supply system consists of four national
taps (catchment, import, NEWater and desalination) with
different costs. NEWater and desalination is under DBOO
scheme. Each year the required selling price is calculated
based on the progress of the cost components, available
capacity and a break-even point. Technical and energy cost
follows two different random walks. To allow for flexibility,
each tap is subject to expansion and reduction

$0.249 / m3

NEWater

$0.300 / m3

Desalination

$0.780 / m3

NEWater
LNG-Desalination
%
Components Cost ($m)
23.45% Capital charge
1.65
42.53%
Investment
5.67
25.80% O & M (fixed)
2.93
8.22%

Variable costs

1.41

REQUIRED SELLING PRICE CALCULATION

Economies of scale :
C kQ m
Required selling price :
Q m 1
RSP u (k F k I )

RSPnew

After expansion :
(Q qe ) m 1
u (k F k I )

Saving from expansion :


S Q ( RSP RSPnew ) qe ( RSPnew RSPj )

Fixed cost
RSP

j i

Break-even
point Q

Max.
capacity Q

Quantity

RISK PREMIUM
To minimize the cost of supplying water means to use the most of the cheapest, and then the next cheapest one.
Taking the cost of imported water as its face value means omitting the potential risks that this tap is cut off. A risk
premium should be incorporated into the cost of imported water when compared with other taps. Risk premiums
ranging from $0.00 to $3.50 are examined in this study.

Two part tariff vs. Unit


tariff
On average, the unit tariff
approach helps to reduce NPV
by 7% because PUB only bears
the capital cost when it
purchases some water. On the
other hand, for the two-part
tariff structure, this payment is
fixed so PUB always has to pay.
However, the difference is small
because the proportion of
investment cost is moderate. In
addition, PUB has the option to
expand when needed in stead of
having to pay capital upfront.
Therefore, it does not have
excessive capacity and wasted
capital.
The result suggests that the
savings from the unit tariff
does not justify the difficulties in
financing the projects of its type.
The dispatch flexibility cannot
balance the procurement costs.

Imported

Desalination
Components
%
Energy (variable) 46.90%
Investment
29.50%
O & M (fixed)
17.90%
Technical
5.70%
(variable)

Variable
cost

COST STRUCTURES
"Unit Tariff per Output" structure: no minimum purchase
obligation, highest flexibility, harder to finance and
procure. All risks belong to the concession company.
"Two-part tariff": currently adopted. Fixed payment
covers project capital, partially reducing risks for the
concession company. Variable payments are dependent
on production and the concession company still faces
market risks.
The second structure is examined since being in used, the
first structure is tested for its value of flexibility.

$0.235 / m3

COST COMPONENTS

Cost/
Revenue

Supply and demand spectra

Catchment

After reduction :
k F ( Q) m k I Q m
RSP u

( Q)
Q
In this simulation model, two values = 0.5
and = 0.75 will be examined.

RISKS
Water security risk: a risky
year is when the averaged unit
cost of supplying a unit volume
of water for a particular year is
greater than $1.00.
Political risk: number of days
Singapore can survive without
the import tap.
Source: PUB

Water security risk


i RSPi U i
WSR
TWC
Political risk
E Consumption - Internal capacity
Reservoir storage capacity
x
E Catchment Capacity
PR max( 365 x,0)

RESULTS
Risk premium and Economies of scale
With m < 1, there is a decrease in NPV when risk premium increases to $0.10.
With m = 1, NPV first increases with a lower rate, then faster.
NPV is very sensitive with premium < $1.50, and insensitive with premium > $1.50.
Increasing risk premium makes local taps more favourable, and increase in local
capacity provides greater flexibility in adverse events, therefore NPV decreases.
If risk premium is even higher, the more expensive local tap (desalination in most
cases) steps in and increases NPV.

Scenarios in favour of local taps will shift the turning point to the right.
Scenarios in favour of imported tap will shift the turning point to the left.
If risk premium > $1.50, local taps are always used up first, hence NPV is not sensitive.
LNG desalination
Water security risk is reduced by 10 20% by LNG
Political risk is reduced by 1 10% by LNG
NPV is reduced by 2 to 7 million with LNG. When there is more
restriction in local taps, this can increase to 25 million. The
difference suggests the maximum allowable cost to put into
research to obtain the implementation option.
Increasing the LNG capacity by 3 times will increase the saving by
6 to 8 times. This is option on option.
LNG desalination is proved to be feasible
Effect of
Changing from = 0.75 to = 0.5 only decreases NPV by less than
2%.

Normal circumstance

Limits on local tap, saving increases,


turning point shifts left