Cyriel de Jong is partner at Maycroft Consulting and affiliated to Erasmus University. Pulished in:
Publication year: 2003
Co-author 1: Kasper Walet
In this paper we describe the decision problem of the manager of a power plant. The plant manager needs to decide on the production levels of the facility based on current and future spark spreads and production costs. Furthermore, decisions need to be made on the optimal hedging strategy with tradable financial contracts in the electricity output and the input fuel. We show that optimal production decisions and optimal financial contracting decisions depend largely on the flexibility with which the facility can be operated, and thus on the level of volatility that may be exploited. On one side of the spectrum, so-called baseload plants will be generating power almost continuously, and hedging financial risks is done with tradable long-term forward contracts, which yields a direct value based on option theory (Margrabe, 1978). On the other side of the spectrum, so-called peaking plants will be generating power only in short periods of high demand, and hedging financial risks is only possible to a very limited extent, since financial contracts on future short-term delivery periods are barely traded. As long as the risk preferences of the plant owner are taken into account, real option valuation and optimal operating decisions can however be obtained for peaking plants by simulating the appropriate market prices in combination with the least squares Monte Carlo simulation approach (Carriere, 1996; Longstaff and Schwartz, 2001).
In this paper we describe the decision problem of the manager of a power plant. The plant manager needs to decide on the production levels of the facility based on current and future spark spreads and production costs. Furthermore, decisions need to be made on the optimal hedging strategy with tradable financial contracts in the electricity output and the input fuel. We show that optimal production decisions and optimal financial contracting decisions depend largely on the flexibility with which the facility can be operated, and thus on the level of volatility that may be exploited. On one side of the spectrum, so-called baseload plants will be generating power almost continuously, and hedging financial risks is done with tradable long-term forward contracts, which yields a direct value based on option theory (Margrabe, 1978). On the other side of the spectrum, so-called peaking plants will be generating power only in short periods of high demand, and hedging financial risks is only possible to a very limited extent, since financial contracts on future short-term delivery periods are barely traded. As long as the risk preferences of the plant owner are taken into account, real option valuation and optimal operating decisions can however be obtained for peaking plants by simulating the appropriate market prices in combination with the least squares Monte Carlo simulation approach (Carriere, 1996; Longstaff and Schwartz, 2001).