A real-option farm-level model on investment in perennial energy crops under risk considerations

Abstract

The stochastic dynamic optimization model documented in here simulates decisions of an arable farm with respect to long-term investment based on a compound American option. The implemented application is an investment in short-rotation coppice (SRC). SRC uses fast-growing trees that, once they are set-up, are coppiced several times and finally cleared-up. Time and scale of SRC introduction, intermediate harvest quantities, and final reconversion are flexible and constitute decision variables along with cropping shares for competing crops. A farmer distributes limited resources, i.e. land and labor, to SRC and competing annual crops. This decision is based on the maximization of the expected NPV under constraints related to policy obligation capturing ecological requirements. The price of SRC biomass and gross margins of annual crops are assumed to stochastic and captured by a stochastic process, but these prices can also be included as deterministic components. The costs of harvests are depicted by a function capturing economies of scale. Moreover, the farmer represented in the model can be assumed as risk-neutral or risk-averse. The model quantifies optimal time and scale of SRC cultivation and allows conducting policy and risk analyses.