Distributed solar renewable generation: Option contracts with renewable energy credit uncertainty

Solar energy is rapidly emerging thanks to the decreasing installation cost of solar panels and the renewable portfolio standard imposed by state governments, which gave birth to the Renewable Energy Credit (REC) and the Alternative Compliance Payment (ACP). To make profits from the REC market in addition to reduced energy costs, more and more home and business owners choose to install solar panels. Recently, third-party financing has become a common practice in solar panel investments. We discuss optimal timing for the host to potentially buy back the solar panels after being installed for a period of time and how to incorporate the optimal timing into a power purchase agreement between the host and the third-party developer. Because the REC price is a major source of uncertainty and also due to the ACP capping the REC price, we first propose a REC price forecasting model that specifically considers the ACP values. Then by a modified real option structure, we model the buyback contract as a real option and solve it with an approximate dynamic program based Monte Carlo simulation method. We find that as the ACP value increases, the value of the buyback option also increases under optimal timing. The method used does not only apply to solar projects but also to other distributed renewable projects that are third-party financed, such as wind generations. (C) 2015 Elsevier B.V. All rights reserved.