Optimal investment decisions with minimum price guarantees under the constant elasticity of variance process

Abstract

This paper offers an analytical setup for evaluating optimal investment decisions associated to a feed-in tariff (FIT) contract with a minimum price guarantee (i.e., a price-floor regime) under the constant elasticity of variance (CEV) model. The proposed analytic solutions can be used to optimally design FIT contractual schemes with both perpetual and finite maturity guarantees. We show that the argument that a perpetual guarantee only induces investment for prices below the price floor when a risk-free investment opportunity is available is still valid under the CEV process. We also demonstrate that the optimal price-floor level triggering immediate investment in the presence of a perpetual guarantee is independent of the elasticity parameter of the CEV model. By contrast, we show that such independence is not valid any more in the case of FIT contracts with a finite maturity guarantee. Our results provide evidence that care must be taken when a policymaker aims to design a given instrument to induce investment decisions with FIT contracts because the differences between trigger points under alternative modeling assumptions are quite significant and the excessive rents are usually paid at the expense of tax payers.