Evaluating the Land Conversion of Annual Crop Production to Cultivate Miscanthus – An Application of the Real Options Approach

Abstract

Several studies applying the classical investment theory have shown that miscanthus (MSC) is an economically advantageous alternative to traditional agricultural land use. Nevertheless, only few farmers cultivate MSC. Therefore, it seems as if farmers do not act according to classical investment theory. In contrast to the classical investment theory, the real options approach (ROA) considers irreversibility and temporal flexibility of an investment as well as uncertainty with regard to investment returns. Consequently, investment triggers indicating when a decision-maker should invest can be shifted upwards in comparison to the classical investment theory. It is therefore often concluded that the ROA can help to explain investment restraint. However, the possibility of disinvestment is often neglected. Thus, there is the risk that calculated investment triggers of the ROA are overestimated. We develop a model by using a combination of a genetic algorithm and stochastic simulation in order to calculate investment triggers in general, and conversion triggers in particular (with and without reconversion possibilities) to the conversion possibility from wheat to MSC following the ROA. Our results show that the conversion triggers of the ROA are higher than those of the classical investment theory. Nevertheless, the neglection of disinvestment (reconversion) possibilities leads to overestimating conversion triggers. However, conversion triggers of the ROA are still higher than those of the classical conversion triggers of both theories decrease. It can be concluded that the ROA has the potential to partially explain farmers' inertia to convert to MSC.