Impacts of Environmental Constraints on the Optimal Decision-Making Process Applied to Brazilian Petroleum Industry
Authors: Lima G.A.C. , Suslick S.B. 
Published: March 2010

Environmental assessment affects negatively the decision to invest when production oil projects are evaluated under traditional analytical methods such as net present value (NPV), because the environmental requirements may generate a delay in the start-up of production. Contrarily, under a real options approach, if the delay period provoked by legal and environmental requirements is close to the investment timing (postponement period), some decisions to produce may be unaffected. Thus, the decision-making process according to the real option theory is more realistic, since it considers uncertainty over future costs and output prices, investment irreversibility, and managerial flexibility (as option to delay investment), which means that the decision is not "now or never" (as in the case of NPV), but "now or wait." This paper discusses an option model based on the stochastic behaviour of output prices, and its relationship with the optimal rules of decisions in terms of timing period. We conclude that, if this period length is longer than that of typical productiondelay time in an offshore oil project in Brazil due to environmental restrictions, decisions to produce are unaffected.

Introduction

Traditional investment analysis, which accepts investments when the discounted values of their expected future cash flows (DCF) are positive and otherwise rejects them, is presently considered incorrect because of its inability to adequately account for uncertainty. For example, according to DCF, delaying the production start due to the additional requirements of an environmental assessment (EA) may affect negatively the decision to invest, because of the time value of money. Although the NPV rule is simple and easy to apply, it is built on limited assumptions, such as assuming that the investment option is irreversible, i.e., if the company does not make the investment now, it will lose that opportunity forever ("now-or-never" proposition). In most cases, investments are irreversible but, in reality, capable of being delayed. Recent research on investment shows that companies with opportunities to invest implement them in a more effective way. Using Real Options Theory (ROT) enables managers to think of their investment decisions as the exercise of a financial all option; they have the right, but not the obligation, to buy an asset whose price fluctuates stochastically (project) at a chosen future time for a pre-specified price (investment). Thus, it is often desirable to delay an investment decision, and wait for more information about market conditions. Also, uncertainty can arise from environmental regulations, and new factors must be taken into account in the decision-making process.

In Brazil, the start-up of petroleum projects demands the approval by government authorities of the EA, which may be costly (even more than $1 million), involve multidisciplinary professional teams, and take from 14 to 18 months to be completed, depending on project size and location.

According to the framework of DCF, this delay in production start up decreases project profitability in terms of NPV and IRR, so it may be decided to abandon the project under a "now or never" proposition.