Korean Energy Economic Review ISSN:1599-7057(Print) 에너지경제연구

Since Solow and Wan (1976), the least cost principle has been generally accepted as a rule for natural resource use. Although numerous subsequent papers reexamined the validity of the least cost principle from several perspectives, none of them investigated this rule in presence of uncertainty. As manifested Dixit and Pindyck (1994) among others, a decision for which resource should be utilized at first is in fact irreversible in a sense that it incurs sunk cost. Hence, in the presence of uncertainty along with irreversible cost, investment decision should be analyzed in a real option framework. This paper provides stylized real option models to analyze the optimal utilization of natural resources. Various forms of uncertainty is separately introduced such as environmental damage uncertainty, electricity price uncertainty, and fuel price uncertainty. The first part of presented model suggests that the least cost principle is still valid even when environmental damage is taken into account. The second part considers a fuel switching problem when electricity price or fuel price follows a stochastic process. It provides an optimal rule at which the least cost principle determines optimal intertemporal allocation of fuels.