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Technological Forecasting & Social Change 77 (2010) 649–661

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Technological Forecasting & Social Change

A real options reasoning approach to hybrid vehicle investments Arman Avadikyan ⁎, Patrick Llerena PEGE/BETA (Université de Strasbourg, UMR 7522 CNRS), 61 avenue de la Forêt Noire, 67 085 Strasbourg, France

a r t i c l e

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Article history: Received 25 July 2009 Received in revised form 19 November 2009 Accepted 2 December 2009 Keywords: Sustainable transport Technological transition Real options Investment strategy Hybrid vehicle

a b s t r a c t Long term increases of petrol prices and the threat of a global climate change have created in the automotive industry a new competitive environment based on the development of more sustainable technologies. Using the real option reasoning lens we provide a theoretical framework to better account for the technological and market uncertainties and irreversibilities that impact the investment and innovation decisions of automotive firms supporting the development of more sustainable vehicle technologies. We investigate the case of hybrid vehicles in a transitional perspective by insisting on their potential to influence the dynamic shaping of investment decisions of firms in the car industry. We consider the hybridization strategy as intra-project and inter-project compound growth options to manage the flexibilities and irreversibilities of investment decisions during the transition process. We provide four different–sometimes conflicting–strategic rationales structuring the investment efforts of firms in hybrid vehicles and illustrate them with numerous examples from the automotive industry. © 2009 Elsevier Inc. All rights reserved.

1. Introduction Long term petrol price increases and the threat of climate change have created in the automotive industry a new competitive environment based on the development of more sustainable technologies. Using the real option reasoning lens we provide a theoretical framework to better account for the technological uncertainties and irreversibilities that impact the investment and innovation decisions of automotive firms supporting the development of more sustainable vehicles. We investigate the case of hybrid vehicles (HVs) in a transitional perspective by insisting on their potential to influence the dynamic shaping of firms' investment decisions. By combining an internal combustion engine (ICE) and an electric motor, HVs have attracted increasing interest by the automotive industry. They are in fact considered in the short term as the most viable alternative propulsion system improving significantly vehicle fuel efficiency and emissions without sacrificing traditional vehicle performance criteria. Furthermore, HVs possess in the long term the potential to facilitate the transition to more disruptive technologies such as fuel cell vehicles (FCVs) and battery electric vehicles (BEVs) because of important spillovers among different technical components and systems which are common to all alternatives. Several contributions have already addressed the role of hybrid technologies from a transitional perspective [1–3]. The originality of our research with respect to existing contributions consists in characterizing investment strategies of firms in the

Abbreviations: ADEME, Agence de l'Environnement et de la Maîtrise de l'Energie; APU, Auxiliary Power Unit; BEV, Battery Electric Vehicle; BMW, Bayerische Motor Werke; CO2, Carbon Dioxide; DEV, Diesel Engine Vehicle; DoE, Department of Energy; FCV, Fuel Cell Vehicle; GM, General Motors; HSD, Hybrid Synergy Drive; HV, Hybrid Vehicle; ICEV, Internal Combustion Engine Vehicle; IEA, International Energy Agency; IMA, Integrated Motor Assist; JAMA, Japan Automobile Manufacturers Association; Li-ion, Lithium-ion; NiCd, Nickel Cadmium; NiMH, Nickel Metal Hydride; NPV, Net Present Value; PEMFC, Proton Exchange Membrane Fuel Cell; PHV, Plug-in Hybrid Vehicle; RE, Range Extender; RITA, Research and Innovative Technology Administration; SOFC, Solid Oxide Fuel Cell; SUV, Sport Utility Vehicle; THS, Toyota Hybrid System. ⁎ Corresponding author. Tel.: +33 368852192. E-mail addresses: [email protected] (A. Avadikyan), [email protected] (P. Llerena). 0040-1625/$ – see front matter © 2009 Elsevier Inc. All rights reserved. doi:10.1016/j.techfore.2009.12.002

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light of the uncertainties that punctuate the transition process towards disruptive technologies. Our contribution is thus mainly interested in clarifying the effect of technological uncertainties on the investment behavior of firms during the transition process. We adopt for this purpose a real options reasoning approach [4–6] where the investment behavior of firms is influenced both by the uncertainties they are confronted with and the irreversibilities of the existing technical system and those they want to avoid to remain flexible. Real option models show that the will to preserve flexibility in the presence of uncertainty and irreversibility induces investment strategies which are different from those advocated by traditional net present value calculus. An important contribution of the real option theory is to show that investment behavior is not confined to a binary choice between ‘invest’ and ‘do not invest’. Rather, decisions are guided by the strategic exploitation of flexibilities and irreversibilities proper to the sequential logic of investments. It is this tension between flexibility and irreversibility that shapes the investment decisions of firms within the transition process. More specifically, by assimilating investment strategies in HVs to compound growth options we provide four strategic rationales structuring the investment efforts of firms in hybrid vehicles and illustrate them with several examples from the automotive industry. These four rationales reflect the different and sometimes divergent perceptions firms can have in the short and the long term potential (option value) of hybrid vehicles and they explain the disparity of strategic postures within the automotive industry. Our paper is structured as follows. Section 2 presents the real option reasoning approach. Section 3 focuses on the simple growth option characteristics of HVs. Subsequent sections investigate the four strategic rationales structuring firms' investment efforts in HVs as compound growth options. First, investments in HVs can be justified as an opportunity to improve the option value to maintain the incumbent paradigm by improving its environmental performance, and act at the same time as a hedging option against the uncertainties which characterize the improvement potential of both the ICE and more disruptive solutions such as FCVs or BEVs (Section 4). A second rationale relates to the uncertainties that affect the very potential of HVs. Under a competitive context, these uncertainties explain the differentiated investment strategies within the automotive industry which pursue either a sequential or architectural logic to innovation (Section 5). A third motivation to invest in hybridization refers to its capacity to contribute to the option value to diversify on a larger set of technological alternatives by changing the way to manage the technology portfolio (Section 6). Finally, we consider HVs from a transitional perspective as a generic investment platform with built-in flexibility to facilitate the deployment of more sustainable disruptive technologies such as EVs (Section 7). Section 8 concludes. 2. Real options reasoning The real options approach [7–9] constitutes a fruitful framework to better understand investment decisions in the presence of uncertainty and irreversibility. Contrasting with traditional investment rules based on the net present value (NPV), this perspective takes into account the value to react flexibly to environmental changes and stresses the impact of varying uncertainty levels and sources on investment decisions. In this sense the real options lens provides a methodology to assess the opportunities and benefits associated to flexible investments. The value of a real option depends on six variables: (1) the present value of risky assets (called underlying assets) to be acquired in order to realize the project on which an option is held; (2) the cost of holding the option (the expenses to hold the option to invest in the project); (3) the cost of exercising the option (expenses to acquire the assets of the project); (4) the duration of the option until its expiration date (decision date until which the option stays open before being exercised); (5) the volatility of the underlying assets; (6) the riskless interest rate during option duration. If there is no volatility, there is no reason to adopt an option strategy since flexibility has no value. In return, for a given level of irreversibility, the option value (of flexibility) increases with uncertainty. Since an option is defined as a right but not an obligation to acquire an asset, holding an option creates an asymmetric risk profile: an option to invest benefits from risky events when uncertainty gets resolved in favor of the investment under consideration by giving a preferential right to exercise the option. If conditions are unfavorable, the option is not exercised and the only cost borne is the one of holding the option (assumed to be largely inferior to the investment cost). Several types of options have been highlighted in the literature, including i.e. the options to wait, to stage, to expand, to abandon, to switch and to grow. Whereas earlier contributions on real options have mainly insisted on the value associated to the option to wait or to defer investments [10], several contributions have recently considered more proactive option strategies such as growth options giving firms a competitive advantage [11]. Even if the logic that underlies both deferral and growth options is based on the value of flexibility, this value does not derive from the same source for each option. Deferral stresses the value to delay investment in order to benefit from the arrival of new information. Growth options insist on the value of early investment in order to develop the capabilities necessary to facilitate preferential access to future opportunities [4,6]. Both options advocate a different investment strategy if we take the NPV as a reference. An investment which could be justified by the NPV rule (NPV N 0) may not be engaged if firms consider the deferral option. According to this option, a firm only invests if the revenues expected from the uncertain project cover not only the investment cost but also the additional option (flexibility) value of waiting. In the case of growth options, an investment can be initiated even if the NPV rule advocates not to invest (NPV b 0). Some irreversibility may be accepted in order to create access to potential opportunities. An early investment is here considered as the opportunity price to participate in the sequence of future expected projects. This ambiguity about the investment behavior of firms compels us to have a closer look at uncertainty sources and to differentiate the role of different environmental and competitive contingencies in order to better understand firms' option choices [12,13].

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Unlike traditional investment models where projects are assessed independently and where their values are considered additively, real option models insist also on the importance of interactions between investments [8]. Generally the acquisition of an option is the key to create new options when a given project can have multi-stage opportunities. The choice of an option can also affect the value of pre-existing options. Furthermore, since holding an option has a cost, adding options to a portfolio does not necessarily increase the portfolio value. A distinction is therefore made between simple options and compound options where the latter are defined as an option on an option. A further distinction concerns intra-project and inter-project compound options [8,14]. Intra-project compound options involve options that are all embedded in the same investment (e.g. options to grow and to abandon). Inter-project compound options involve options embedded in different investments and relate to different underlying assets (e.g. sequential growth options). In this framework, interactions among options may be substitutive, additive and synergetic and an option portfolio strategy might be considered as a trade-off between different options according to the uncertainties firms prioritize. In the following we will consider HVs as growth options and use the distinction between intra-project and inter-project compound growth options to differentiate firms' investment strategies (Fig. 1). Before developing our main arguments on HVs as simple and compound growth options, we briefly insist on some key debated points on the applicability frontier of real options. For Adner and Levinthal [15], three assumptions complicate the applicability of the financial option theory to “real” investments: (1) whereas the financial option value (and that of the underlying asset and its exercise price) is exogenous to the investors' actions; firms do not hold real options passively. Rather the decision to hold an option motivates a firm to improve its value by trying to change the value of the underlying assets; (2) whereas the market signal on the financial option value is observable, the value of a real option is difficult to assess by merely relying on market signals; and (3) whereas the expiration date of the financial option is fixed ex ante, most options on strategic opportunities do not have an explicit expiration date. Their expiration date is rather contingent on resources committed by firms and on their competitive context. Adner and Levinthal [15] argue that these differences can disable the abandoning or the striking of a real option at the appropriate moment because of organizational bias and stakeholder interests. Therefore when firms can endogenize uncertainty through strategic actions, the validity of the real option methodology to assess appropriately investment opportunities can be seriously questioned. Other authors, on the contrary, stress the importance of endogeneity in order to manage uncertainty proactively and account for the strategic behavior of firms [16]. The violation of these assumptions, if it complicates the application of option theory to ‘real’ investments, contributes at the same time to take into account the cognitive and strategic dimension of actors' rationality. Whenever these assumptions do not hold, the fact that options correspond to a right but not an obligation exacerbates the strategic dimension of decisions. By holding options, firms generate future decision rights and act according to the value they attach to them. In fact the value of an option depends on the specific uncertainty and knowledge profiles of each firm. A corollary is that the same option may be held by several actors for different reasons. Thus, holding an option to grow may be motivated by the decision right it confers to wait as well as to invest. Holding, abandoning or striking options can here be interpreted as providing actors the ability to orient trajectories and to influence the balance of selection criteria for investments. To the extent that options concern future investment, their value results from the convergence of actors' expectations as well as the flexibility of their interpretative schemes concerning their potential opportunities. The value of an option is thus a question of interpreting problems (and solutions) and of competition between possible world visions. These perceptions influence in turn the recognition of opportunities and firms' action strategies. 3. The HV as a growth option: opportunities and uncertainties Growth options insist on the value of early investment in order to develop the capabilities necessary to facilitate preferential access to future opportunities [17,18]. Investments in HVs entail substantial, although highly uncertain future opportunities for the automotive industry and are therefore considered as growth options.

Fig. 1. HVs as compound growth options.

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Fig. 2. Patents applied by car manufacturers. Source: [21].

Since HVs use the same infrastructure as conventional vehicles, technological/economic challenges to introduce them on the market are less demanding than BEVs and FCVs. Therefore, although not being a «zero emission» vehicle, the HV is one of the rare technological alternatives which has the potential, in a relatively short time horizon, to contribute to efficiency gains and CO2 emission reductions in the automotive sector [19,20]. Several signs reveal that the car industry considers increasingly the HV as a growth option strategy to improve the environmental performance of cars. The analysis by Oltra and Saint Jean [21] on patents applied by car manufacturers until 2005 illustrates the strong involvement of the car industry particularly in HV and FCV R&D since 1999–2000. Cumulated HV patents become even superior to EVB patents from 2002 and remain also superior to FCV patents in 2005 even if the latter display a significant increase since 2001 (Fig. 2). Furthermore, HVs such as the Prius (Toyota) and the Insight (Honda) are until now the only alternative to ICEVs and DEVs to have emerged on the market even if their share remains still marginal (Fig. 3). Other car manufacturers offer also or intend to do so models with different hybridization levels and have invested in limited production capacities to test the market and support their technological leaning process. Despite HVs being considered at the industry level as a growth option, we nevertheless observe significant differences among firms with respect to how they conceive their opportunity commitment decisions to develop HVs. Before qualifying these strategic differences in the next section we intend in the following to better characterize the uncertainties and barriers which might affect the deployment of HVs and which structure the opportunity perception of firms and the value of HVs as a growth option. Sperling and Lipman [26] formulate firms' dilemma with respect to the decision to engage in the development of HVs in the following way: “In some sense, hybrids are a middling technology. They do not have a distinct superiority along any dimension and present a muddled image to consumers. Compared to ICE vehicles, hybrids have better energy efficiency, easier‐to‐control emissions […] and, like all electric‐drive vehicles, a superior driving feel […]. But due to redundant power plants, they are inherently more expensive and possibly less reliable than ICE vehicles. Hybrids have longer range and smaller batteries than battery EVs, but are technologically more complex and […] present a less pure environmental image […]. Are hybrid vehicles likely to dominate? […] Are they a second‐best option that will be delayed in the near term and succumb to fuel cells and other technologies in the long term?” First, an important obstacle to the diffusion of HVs are their price premium related to components such as batteries, power electronics, the electric motor, the vehicle monitoring unit and the higher architecture complexity [27–29]. Because of their higher

Fig. 3. Share of HVs in total new vehicle sales. Source: [22–25].

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cost, HVs have only captured a negligible market share since their introduction a decade ago. Even if the cost of HVs can drop by technological learning and mass production, the very principle of hybridization consisting in combining several technological innovations is likely to keep their cost high. This cost can hardly be borne by compact vehicle segments which represent the large majority of the vehicle fleet and the HV might in this case only concern some niche segments such as SUVs. The second uncertainty is related to the fuel efficiency of HVs. In most cases the fuel economies achieved by HVs during real driving conditions are lower than those observed during test driving conditions. It turns out that, more than for conventional cars, the efficiency of HVs is dependent on usage patterns [30]. The use of energy intensive auxiliary units such as air conditioning onboard vehicles reduces also significantly the efficiency of HVs [31]. Furthermore since the promotion of HVs is based upon their «lack of compromise», one important risk is related to rebound effects through the power increase of cars to justify the premium price and limiting thus their benefits in terms of fuel efficiency [19]. A third uncertainty relates to the short and long term competitiveness of HVs. In the short term, competition might be fierce less between ICEVs and FCVs or BEVs than between hybrid and advanced diesel engine vehicles. The preference for gasoline hybrid rather than diesel vehicles in the US and Japan is mostly explained by the more severe legislation on pollutant emissions in these countries compared to Europe. For the latter, the generalization of the diesel car fleet and the cost advantages of advanced diesel engines compared to HVs make the market breakthrough of HVs less likely [32,33]. In the long term, technological advances that favor the diffusion of HVs might also benefit EVs. This would make the hybrid alternative only a transitional investment, questioning the development of a dedicated HV industry. Advances made on lithium-ion (Li-ion) batteries which provide both high power and high energy densities, make them relevant not only for HVs but also for plug-in rechargeable HVs (PHVs) and BEVs [34,35]. Li-ion batteries are likely to favor in some segments such as urban vehicles, where HVs are the most beneficial in terms of fuel economy, the development of BEVs with the sufficient range for urban drives. The above opportunities and uncertainties confer to the HV an optional character which is exemplified by the increasing patent race at the industry level and the introduction on some niche markets of such vehicles. Having in mind these uncertainties and opportunities, we will in the rest of the paper qualify more precisely firms' investment and resource commitment strategies on HVs as compound options.

4. The HV as a hedging strategy and the option value to maintain the ICE In this section, we show that the HV has the properties of an intra-project compound growth option, that is a set of nested options embedded in the same investment. As shown by the real options literature most option strategies embed multiple options and the value of an option generally depends on the value of other options it is built upon and the value it confers to them. We will show that growth options on the HV derive partly their value from on the one hand the option value to maintain the ICE and on the other hand from being a hedging option against several uncertainty sources. Since one of the distinctive features of HVs is the synergy between the ICE and other alternative technologies, growth options on HVs derive part of their value from the option to maintain the ICE. HVs create in fact a new perception for both the dominant and the alternative paradigms. The increase in the option value to maintain results from the interdependency created by HVs between emerging and existing technologies. The growth option value of HVs is derived from the higher margin created to optimise the ICE by being progressively associated with the innovations and functionalities of emerging technologies. But, advances on HVs also depend on incremental and cumulative innovations on the ICE and the whole vehicle. Thus, the benefits from hybridising rest also upon the importance of technological innovations on advanced ICEs. First, the value of the option to maintain the ICE relates to the path dependencies that structure the automotive industries' investment behavior (technological and mass production competencies accumulated on ICEVs, network complementarities and fuel infrastructures). When organizational change is disruptive, regime actors may hesitate to shift radically the system, hoping that future states of the world will allow the incumbent regime to become more attractive. Actors may thus delay exit, even if the NPV of ICE projects becomes negative and investments on the incumbent regime may continue until the economic losses exceed the option value to keep the incumbent system [36]. Second the value of the option to keep the ICE derives from the fact that the environmental performance of ICEs represents a relatively recent concern in the history of the automotive industry where innovation efforts have traditionally been guided by attributes such as engine power, autonomy, security and reliability. Investment strategies aim thus to exploit the ICE by exploring solutions to improve its environmental performance. The option to keep the existing system may thus be justified because of the perception that its technological frontier has not yet been exhausted. As Chi and Nystrom [37] argue, a higher uncertainty on the evolution of the dominant technology means a higher learning potential and may conduce firms to exploit it more intensively until the cost of such learning becomes higher than the benefits expected. Third, the value of the option to keep the ICE derives from the uncertainties relative to the technical and commercial feasibility of long term alternatives such as FCVs and BEVs. In fact, the more important uncertainties on future technological alternatives and their adoption costs, the more regime actors might rationally choose to persist on technologies that might prove inferior in the long term. In other words, the higher the uncertainty level, the more firms will be keen to lengthen the life span of existing solutions with a low capital cost. Inertia in this case mirrors the expectations concerning the value of present and future technologies and the cost of change. This inertia increases with uncertainty since firms are rationally hesitant to support the cost of change towards competences which might become obsolete if the environment returns back to its previous state or because of the risk to choose the wrong alternative.

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The growth option value of HVs apart being highly dependent on the option value to maintain the ICE derives also its value by acting as a hedging option to moderate different uncertainties firms are faced with. The hedging option value of the HV stems for instance from its capacity to compensate the weaknesses of the ICE in cases where it makes limited progress. But the hybrid system as a hedging option can additionally increase the flexibility of the existing fossil fuel paradigm. In fact the fuel economies obtained with HVs can notably smoothen the pressures brought upon the diversification and usage of other primary sources than petroleum for the production of liquid fuels. In the same way the growth option value of HVs derives from being envisaged as a hedging strategy against uncertainties with regard to the long term evolution of BEVs and FCVs. In fact the deployment of HVs does not depend on the development of a new hydrogen infrastructure for FCV and/or an electric network to charge the batteries. Instead the success of FCs and batteries but also the use of hydrogen and electricity as energy vectors in vehicles are tributary on a number of complementary factors which make their adoption highly uncertain. In the case of batteries, uncertainties concern their cost, reliability, security, autonomy, life expectancy, their recharge time [35,38]. These uncertainties and repeated failures to introduce in the past BEVs [39,40] in the market have led some authors to qualify them as an “eternally emergent” technology [41]. The challenges are of the same order for FCs and concern their cost, duration, life span, operation under low temperatures, the possibility to substitute in FCs precious metals such as the platinum. As for batteries for the electricity storage, the storage of hydrogen on board vehicles remains a critical factor for the success of FCV [42,43].

5. The HV in a competitive context: sequential vs. architectural growth options In the preceding section we interpreted the HV as an intra-project compound growth option deriving its value from being a set of nested options embedded in the same investment. In this section we show that the HV has also the properties of an inter-project compound option deriving its value from the flexibility it gives to car manufacturers to structure their investments sequentially. Although HVs are considered industry-wide as a growth option, it is important to take into account the competitive context of the automotive industry and firms' specific perception of uncertainties and opportunities concerning this technological trajectory in order to better specify option management strategies. In fact, competitive dynamics can have effects on option choice, option creation and exercise [11,12]. Although an increase in uncertainty raises the value of the investment deferral option, when there is strategic interaction first-mover advantages can make early investment (growth option) more valuable and prompt early exercise of the option. However, under circumstances where delayed market introduction is beneficial, such as when there are secondmover advantages [44] or when a new product may cannibalize existing or other promising products of the firm [45], a company may adopt a more cautious behavior and follow an incremental investment process [4]. The HV case is a rich illustration of the way an emerging trajectory can provide in a highly competitive context actors with opportunities not only to exploit it but also to create and explore new growth option strategies. It shows how the commitment of some firms on the hybrid solution has created at the industry level a new focal competition field. Within this field, firms have on the one hand engaged efforts to participate to the standard competition at the architectural level of HVs. But they have at the same time privileged a more sequential and incremental growth option logic to reduce the risk of making early commitments given the uncertain prospects of HVs. One should notice that HV projects by Japanese firms, particularly by Toyota [46], have from the outset considered to incorporate all the functionalities offered by the hybrid solution to improve the efficiency of cars. The project launched by Toyota in 1992 has led to the commercialization in 1997 of the first full HV (the Prius) based on an architectural innovation, the particularity of which was to go beyond the dichotomy between two architectures generally used separately for hybrid motors: the serial and parallel architectures. Called the Toyota Hybrid System (THS) this new serial-parallel architecture was based on the development of a new transmission principle taking advantage of both architectures. Important revisions took also place for the second Prius II version (commercialized in 2003) based on the Hybrid Synergy Drive (HSD) which enabled the electric motor to acquire a larger role to support the performance of the vehicle. The early commitment by Toyota, as illustrated by its growth option choice on the HV shows both the importance given by the Japanese firm to the hybrid concept in its long term strategy and the efforts made as a first-mover to define a dominant standard for the HV architecture. Selling its first HV production series at a loss is also in line with the desire of Toyota to speed up the learning process on its technology and to promote its proprietary technology as a standard. Since the dynamics initiated by Toyota most car manufacturers consider the architectural choice as a key part of their hybridization strategy. One can distinguish, at this level, noteworthy differences among firms. Honda has chosen a parallel only architecture by developing a new transmission system, the Integrated Motor Assist, used for its Insight, Civic and Accord hybrid models. As opposed to Toyota, the hybrid by Honda belongs to the mild category and has thus a lower premium cost. As for Nissan, after mixed results on its own proprietary full hybrid Tino model, the company acquired a license on the Toyota technology for its Altima model. A similar strategy is carried on by Ford who concluded a license agreement with Toyota and still continues to develop its own system. While adopting the Toyota technology such a strategy enables car manufacturers to accelerate their HV market growth. A third group of firms including GM, Chrysler, Daimler and BMW has initiated an alliance which successfully developed its own parallel architecture called «2‐mode hybrid» most appropriate for the high power SUV segment. Finally, some car manufacturers as Peugeot and Daimler are more interested in the long term potential of diesel HVs. Although these strategies may differ, all car manufacturers aim to catch up with Toyota, either by developing new architectural variants around the parallel architecture or by accelerating their market introduction in a differentiated way.

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Fig. 4. HV characteristics and functionalities according to their electrification level. Sources: [33,34,48].

Beyond these differences on the architectural level, the trend within the automotive industry has been to orient growth option strategies towards a more incremental logic than the one initially adopted by Toyota. In spite of the growth options held by some firms on full hybrids, mostly in the US and Japanese markets, the different uncertainty factors that prevail concerning their deployment, have led most of them to adopt a less risky position. Although attractive, the full hybrid concept implies in fact an in-depth transformation of production processes, the development of dedicated platforms, and a change in the internal organization of system integrators and of their interactions with their suppliers [47]. To this should be added that the full HV represents a technology where the different system components are in a state of flux. Rapid technological improvements thus involve the risk that premature investments become rapidly obsolete implying unrecoverable sunk costs. Thus, in the short term, alternatives relate to the appropriate choice as to the scale of hybridization. The emergence of different hybrid categories (Fig. 4), depending on the electrification scale illustrates an industrial orientation which mainly endeavors to get the HV in line with an incremental investment trajectory where actors sequentially hold and exercise growth options as uncertainties get progressively resolved (Fig. 5). This is in line with the perception that each stage of hybridization involves its own payoffs and sources of uncertainty and that, sequential options although interrelated, have each different underlying assets. These strategies can thus be assimilated to sequential inter-project compound growth options, that is, options whose exercise generates short term cash flows by at the same time bringing forth additional options. In this sense holding and exercising an option on micro hybrids or soft hybrids is likely to open the door to follow-on investment opportunities (subsequent growth options) on higher hybrid category levels by giving firms the flexibility to adapt their future strategies to negative as well as positive unexpected developments in the HV market.

Fig. 5. The HV as a sequential compound option investment strategy.

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For most car manufacturers micro and soft hybrids possess the potential to provide up to 80% of the efficiency of full hybrids by at the same time avoiding their high cost premium [49]. These two categories represent therefore an attractive solution to improve significantly vehicle efficiency without taking prematurely risky and costly development efforts on full hybrids. We thus observe within the industry a variety of approaches exploiting and exploring more intensively the potentials of low hybrid categories. One should notice that according to the regions considered, firms' investment behavior reveals different growth option strategies. Car manufacturers established mainly on the European market aim to introduce HVs on the mass market segment by focusing their growth efforts in the short term on micro and soft hybrids conceivable also for diesel engines. Firms mainly operational in the US market, focus principally on the full HV by adopting a niche growth strategy aiming at luxury and SUV segments (Daimler, Ford and GM). A third group of firms, mainly the Japanese, whose markets are more diversified, adopt an intermediary position. Honda aims the mass market segment with its mild HV and Toyota although having pioneered the full HV offers also different hybrid categories including both micro hybrids (Toyota Witz) and soft hybrids (Toyota Crown). 6. Hybridization and the option value to diversify Up to now we have approached the hybrid concept as a growth option strategy to contribute to the flexibility of and the option value to maintain the dominant paradigm around the ICE. This section considers the hybridization strategy as a set of parallel growth options focusing on its role as a vector for technological diversification. We show that the hybrid concept can be approached as a strategy contributing to the preservation as well as the creation of technological diversity for vehicle propulsion systems by affecting the resource allocation structure among technologies [50,51]. We assimilate HVs to a technology portfolio management strategy influencing positively the value of growth options on a larger set of alternative technologies. The portfolio diversity resulting from the hybrid concept derives principally from the different combinations possible between technologies in order to create new improvement potentials. An important feature of HVs is that they pave the way for a more synergistic approach between technologies [52]. Such synergies transcend the antinomy between radical and incremental innovation approaches and modify the interaction dynamics between technologies. In so doing hybridization favors the emergence and the creation of new concepts and functionalities. It also facilitates the variety of trial–error processes which are necessary to sustain exploration activities by at the same time providing emerging technologies an exploitation base [53]. In evolutionary terms, hybridization changes the selection environment of innovation activities and promotes the coexistence of technologies [54] in the sense that it proceeds by combination to get around the limits of technologies taken separately. Hybridization alters in fact the investment conditions on alternative technologies and hence the value of their growth options and creates portfolio effects where holding or exercising a growth option on HVs influences the value to introduce, hold or exercise other options in the portfolio. Portfolio diversification effects of holding HV growth options can be defined on the one hand through correlations existing between underlying assets (correlation effect) and on the other hand through the constraints which hang over exercising some options (constraint effect) such that if there are n growth options in the portfolio only m may be exercised (with m b n) [55]. First, hybridization increases the positive correlation between different underlying assets since it creates complementarities among technologies. This increase in correlation through technological clustering affects in turn positively the growth option value on a larger set of alternative technologies and justifies introducing them in the portfolio, keeping them open or exercising them. A case worth mentioning is the diversification of different battery types for HVs [27]. HVs have in fact become in recent years a platform to experiment different established battery technologies such as advanced lead-acid batteries as well as new generation batteries including NiMH, NiCd and Li-ion batteries. It is mainly through its use within HVs that for instance the NiMH battery has been more largely diffused in the automotive market. Next generation HVs represent also an opportunity to introduce in transport applications the Li-ion battery, already massively used in portable electronics, and which is considered in the long term as the most appropriate choice–because of its high power and energy densities–for plug-in or grid-connected HVs and BEVs. Another example is given by the association of batteries and fuel cells. Jeong and Oh [56] show that if the cost of fuel cells remains high, hybridization can reduce the life-cycle cost of fuel cell vehicles, increasing thus their growth option value. This explains the increasing orientation of car manufacturers towards hybrid FCV prototypes [57]. Since, on their own, the costperformance of FCs do not allow them to satisfy the market selection criteria, their combination with other technologies creates better prospects for their market introduction. A similar path can be observed for BEVs. To overcome the performance and range limits of batteries car manufacturers combine them with other alternative technologies. A first association envisaged is the use of ultra-capacitors for power assist alongside batteries. A second association considers using batteries with a secondary energy source as a range extender (RE) producing electric power to increase the autonomy of the car. A third alternative resides in installing solar cells at the roof of cars to provide energy for dashboard electronics to allow for smaller capacity batteries [58]. Each combination increases respectively the growth option value of ultra-capacitors, of solar cells in automotive applications and of the RE technology. The second effect of hybridization on diversity is related to the constraint which bears upon the possibility to exercise options held in the portfolio. In fact, when there is a strong constraint on exercising several options as in the case when at the end of the selection process only one technological system is likely to dominate, each new growth option added to the portfolio has a decreasing marginal value since it has a lower likelihood to be exercised. However, by creating new combination opportunities, hybridization has a relaxing effect on the exercise constraint and increases thus the option value to diversify. We can illustrate this effect through the variety of new functionalities endorsed by several technologies in HVs. The hybridization pattern relaxes in fact the exercise constraint on growth options in that it gives the possibility to alternative

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technologies to perform functionalities which are more suited to their technical characteristics at a given moment in time. By creating new functionalities hybridization generates new potential markets for alternative technologies. It allows exploring different market segments by exploiting their differentiated needs. Whereas FCs have been used generally as a primary energy source in vehicles, their hybridization with other technologies allows them also to function as an auxiliary power unit (APU) or a RE. For instance BMW which has explicitly expressed its skepticism on FCs as the main energy source for cars, is actively involved in R&D on this application not only to built-up its technological position and develop absorptive capabilities but also because the company aims (in partnership with Renault) at using FCs principally as an APU. Recently, vehicle prototypes have also been developed where the RE function in BEVs is performed by FCs. Among car manufacturers, Peugeot has been one of the first to focus on FCs as REs to overcome the limited range of batteries. Such a hybrid concept, beyond overcoming the limits of batteries, makes the exploitation of FCs easier since they use lower power and lower cost FCs. Furthermore in such a system the quantity of hydrogen carried on board the vehicle remains quite low and facilitates refueling by using exchangeable hydrogen tanks. Recently Ford and GM have presented prototypes where the FC system functions as a RE. Also while the PEM trajectory has since the beginning been considered as the dominant choice for transport applications, the application of FCs as APUs and REs has led the car industry to consider the SOFC trajectory, traditionally developed for stationary applications, for transport applications [59–61]. Also keeping and continuing to innovate on the ICE could be critical to the acceptance of BEVs. Given the limited autonomy of batteries, the use of the ICE as a RE in a BEV requires to develop and to explore dedicated motors for this new usage pattern [62]. Contrary to the hybridization trajectory presented in the preceding sections the role of the ICE is here more in line with a logic where it supports and contributes to the acceptance of the BEV or the hydrogen ICE vehicle. 7. The HV as a generic innovation platform to manage built-in flexibility We have in what precedes suggested that the hybridization strategy by modifying the selection environment for technologies influences the value of growth options on a larger set of technologies and contributes to create a higher technological diversity. This diversity increases in turn the uncertainty on the technological standard that might be adopted. This uncertainty stemming from technological diversity might also explain the recent development of generic technology platforms by car manufacturers around the hybrid architecture as options to strengthen its built-in flexibility in a transitional perspective. Built-in flexibility is motivated by the fact that hybridization not only acts upon the value of growth options for alternative technologies but it also reduces the threshold value to exercise these options and their duration since it has a positive effect on the likelihood that uncertainty gets resolved in favor of these technologies. From a transitional perspective, the hybrid platform can be conceived as being an inter-project compound option structured by several types of embedded options to expand, to stage and to switch investments in order to preserve the built-in flexibility to adapt to technological changes in the limits of what can be assumed to be predictable. We have in what precedes argued that the hybridization strategy by modifying the selection environment influences the value of growth options and contributes to create higher technological diversity. This diversity increases in turn the uncertainty on the technological standard that might be adopted. This type of uncertainty stemming from technological diversity might also explain the recent development by car manufacturers of generic technology platforms around the hybrid architecture as options to strengthen its built-in flexibility in a transitional perspective. Built-in flexibility is in fact motivated by the fact that hybridization not only acts upon the growth option value of alternative technologies but reduces also the threshold value to exercise these options by having a positive effect on the likelihood that uncertainty gets resolved in favor of these technologies. From a transitional perspective, the hybrid platform can be conceived as being an inter-project compound option structured by several types of embedded options to expand, to stage and to switch investments in order to preserve the flexibility to adapt to technological changes in the limits of what can be assumed to be predictable at a given moment in time. A critical aspect in transition management processes is the capability of actors to trade-off short term and long term investment horizons [63,64]. In this context an argument in favor of the hybrid platform relates to the transition dynamics that it is likely to create towards the progressive electrification of vehicles. A notable quality of hybrid technologies is in fact to facilitate the coexistence of different time scales in the decision making process and to synchronize technologies which usually are asynchronic. Hybridization creates in fact short term opportunities for technologies that normally are envisaged as long term solutions and can therefore be used as a transition vector to provide the impetus for the emergence of more disruptive technologies [2,65]. While developed in the continuity of the existing trajectory, the HV can progressively create path dependencies which may pave the way to BEVs or FCVs. FCs and batteries can during this hybridization process satisfy cumulatively several electrical functionalities by being adopted first as secondary energy sources and then become the main source of propulsion for vehicles. Currently it is the progress made by batteries used in HVs that mainly explains the renewed interest on PHVs and BEVs. Based on these prospects, several contributions [47,66] stress the importance that hybrid architectures might have as a flexible platform to define the vehicle of the future (Fig. 6) and notice the importance the hybrid architecture might have on vehicle design in the long term and its potential to become a learning platform for alternative technologies such as fuel cells, batteries, electric motors and PHVs. By stressing the strategic importance of electric and hybrid propulsion platforms, Ahman and Nilsson [66] insist on their flexibility and versatility: “It [the platform] can be used for several short term alternatives, such as mild hybrids, which are fairly compatible with the existing technology paradigm (i.e., the ICEV), as well as for the long-term alternatives such as FCVs, which require more fundamental changes in e.g. infrastructure and supporting industrial networks”. Investments by car manufacturers in

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Fig. 6. The HV as a flexible and generic innovation platform.

hybrid architectures may here be motivated by the will of using more quickly a larger set of knowledge created in different technological fields in order to feed continuously and keep vivid their innovation process. A critical question however is related to the appropriate management mode of the innovation platform and its built-in flexibility considering that actors have different perceptions on the possible evolution of HVs, BEVs and FCVs. In fact, the development of platforms with built-in flexibility is determined by a dual dynamic which is both architectural and modular and the relative importance of which depends on the way firms manage their option strategies. This built-in flexibility can either be based on the efforts to preserve a set of options from the earliest design phase of an integrated technical system in order to keep it resilient to possible technological changes or it can focus on the modularization of the technical system in order to provide it the flexibility of a portfolio of independent options [67–70]. In the case of the HV, its architectural dimension can be assimilated to a highly integrated system requiring a deep understanding of the complex interactions between all its components and a calibration of numerous parameters that affect system optimization [47,71]. In this context a strategy focused on preserving options within the integral architecture might be of crucial importance to keep its capability to evolve. At the same time, the hybrid platform is characterized by modular innovations on components such as batteries, fuel cells and the electric motor. Since hybridization is based on the use of a greater variety of technologies that can evolve through time, investments in modularizing the platform should be critical to keep the flexibility to value independently different innovation processes. Such modularity is critical because the economic viability of the hybrid architecture depends on its capacity to reuse elements developed in the past without altering the whole architecture. As for traditional platforms, recent hybrid models are based on the will to share among different vehicle generations the R&D costs engaged by car manufacturers. The role that the hybrid architecture might play in the long term as an innovation platform is particularly well illustrated by the strategy of some car manufacturers such as Toyota, GM and Daimler in designing their future oriented vehicles. Although based on different hybrid architectures, all follow a similar strategy aiming to focus on their built-in flexibility. For Toyota, the following excerpt reveals the structuring role played by the hybrid platform in the innovation strategy of the company: “…, Toyota has long pursued R&D of conventional gasoline and diesel engines, as well as power trains that are compatible with such various energy as biofuel, electricity, and hydrogen. Of these technologies, since hybrid technology can be applied to all types of power trains, we have positioned it as a core technology and are aggressively pursuing its development. Introducing these R&D results in products, we are taking a multifaceted approach to providing “the right vehicle, at the right time, in the right place” [72]. We can suggest that the specific hybrid platform adopted in the case of the Prius, combining the characteristics of both a parallel architecture (close to the ICE) and a series architecture (close to the BEV) corresponds to a strategy of preserving a set of options within a complex integrated system. The challenges that Toyota had to overcome in order to use a high voltage circuit up to 500 V, to develop a new transmission principle based on the planetary gearing system, to keep separate the generator from the drive train reflects the will to safeguard the flexibility of its hybrid architecture to integrate future technological changes. The recent extensions of this architecture through its plug-in version and the efforts to increase the electric range of the vehicle illustrate the adaptive capacity of Toyota's hybrid concept. A different vision is found in the hybrid platforms E-Flex and Blue ZERO developed respectively by GM and Daimler for their future vehicles. These platforms are based on a series architecture and have therefore only an electric propulsion mode. A specificity of the E-Flex platform is the lack of a technical connection between the drive train and the generator to charge the batteries, allowing thus to use several options as the electricity source (ICE or fuel cells) without changing the platform architecture. Such a platform is an attempt to develop a modular design with the ability to adapt to future technological changes in advanced propulsion systems. The Daimler Blue ZERO concept is also based on a modular platform with three possible

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configurations according to the electric propulsion system envisaged: (1) batteries; (2) fuel cells; and (3) an electric motor using the ICE as a generator. Nevertheless, contrary to the Prius platform which positions itself in the continuity of the existing ICE paradigm and which integrates the possibility of a trajectory with an increasing electrification of vehicles, the GM and Daimler platforms adopt straightaway the EV paradigm by at the same time taking into account the uncertainty as to the choice between alternative electric propulsion modes. 8. Conclusion By adopting a real options reasoning approach we tried to provide a more qualified explanation of firms' investment decisions and patterns on HVs as a technological strategy to remain flexible and manage proactively technological, market and policy uncertainties. By assimilating investments in HVs to compound growth options we suggested possible rationales structuring the strategic positioning of firms on this technology and illustrated them with several examples from the automotive industry. These rationales reflect the different and sometimes divergent perceptions firms can have in the short and the long term potential (option value) of hybrid vehicles and they explain the disparity of strategic postures within the automotive industry. In fact although HVs are considered industry-wide as a growth option strategy, a closer look on their technological characteristics reveals that such vehicles can be assimilated to compound growth options embedding a series of embedded options. Considering these second order options allows in our paper to differentiate four types of growth option strategies. Growth options on HVs can in fact be motivated by being: (1) an option to maintain the existing technological paradigm and a hedging strategy against long term uncertainties; (2) an option to act sequentially to limit HV project risks; (3) an option to diversify and (4) a platform with built-in flexibility option. The choice and intensity of each of these growth options may depend on the perception of firm specific as well as industry-wide uncertainties that may be different and even divergent among firms and over time as new information is revealed and new knowledge is acquired. The four compound option strategies may also display conflicting and synergetic interactions among each other. The options to hedge and to maintain the ICE (the HV as set of nested options) and the sequential investment options are complementary and reinforce each other. They contribute all to improve and perpetuate the existing regime. Also the option to diversify (the HV as a set of parallel growth options) and the built-in flexibility platform option reinforce each other. But they see their value increase because of their potential to support the transition process towards more disruptive technologies. Consequently, a HV growth option which derives its value from the option to maintain the ICE and acts as a hedging option might be in conflict with both the option value to diversify and the option value of platforms with built-in flexibility. As a matter of fact, since increasing hybridization narrows the environmental performance and efficiency gap between the ICE, the BEV and the FCV, the HV may affect negatively the possibility for other alternative technologies to be marketed autonomously. Policy support schemes have evidently contributed to influence firms' investment efforts in developing and marketing alternative vehicles, including HVs. Public R&D subsidies for fuel cells and batteries have intensified firms' long term efforts to advance electric vehicles. Nevertheless taking into account uncertainties with regard to these alternatives, regulations on the reduction of CO2 emissions have overall pursued, in line with the market oriented innovation logic of the car industry a progressive trend favoring mostly the commercialization of more efficient ICEVs and HVs. In view however of the compound option characteristics of HVs, an important policy implication is to consider and examine the long term prospects of HVs through their technology diversification effect and as built-in flexibility platforms. Policy decisions to push and pull technological development and support transitions raise in fact concerns about technology selection and the risk of creating new technology lock-ins. In this context HVs can provide governments a possible alternative to combine short term and long term technology policies by taking into account their compound option characteristics and factoring in their limits and potentials to contribute to the transition towards ‘zero emission’ vehicles. Acknowledgments The authors would like to thank two anonymous referees for their constructive comments on an earlier draft of this paper. We would also like to thank the PREDIT which is a program of research, experimentation and innovation in land transport, implemented by the French ministries in charge of research, transport, environment and industry, the ADEME and the OSEO Innovation. References [1] M. Hekkert, R. Van den Hoed, Competing technologies and the struggle towards a new dominant design: the emergence of the hybrid vehicle at the expense of the fuel cell vehicle, Greener Management International 47 (2006) 29–47. [2] R. 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