[BETA] Fortnightly

THE RAPID DEREGULATION OF THE BULK POWER MARKET has exposed utilities and power generators to the harsh reality of spot price volatility. This new reality begs the question: How can merchant generators, independent power producers and investor-owned utilities analyze their risk exposure when energy prices vary daily or even hourly?

The answer lies with spark spread options (em the link between electric power and gas prices.

The spark spread, from a generator's perspective, refers to the difference between spot market prices for electricity and natural gas, expressed in equivalent terms through the nominal heat rate of the gas-fired unit under consideration. Reconciling the spark spread concept with actual spot prices creates the "spot market heat rate," which plays a critical role in the decision of the power plant operator to dispatch individual units.

The broader question, however, is how to integrate this spot market heat rate with information from the futures markets to calculate the present value of generating resources. What is a gas-fired plant worth today, based on the chain of traded futures contracts in power and gas? For that sort of determination, we introduce a discussion of the Black-Scholes option pricing model made famous by the work of Fisher Black, Robert Merton and Myron Scholes; the latter two won last year's Nobel Prize in Economics. As we will show, the Black-Scholes model can be applied to energy markets to infer the value of power plants, but only with certain caveats.

Heat Rates, Spot Markets and Profit

Consider an investor-owned utility that operates generating assets consisting of gas turbine units of varying heat rates. Associated with every natural gas-fueled power plant is a measure of energy conversion efficiency, or heat rate, which determines the amount of gas input, measured in British Thermal Units, required to produce one kilowatt-hour of electricity. A lower heat rate implies that the generation unit has a higher operating efficiency. A variety of economic factors exist that can help the operator decide whether to run his plants; among them are electricity and natural gas spot prices and unit heat rates. To the extent that the operator knows his fuel costs and the efficiency of his generation units, his decision criterion to fire up the plant is the following: Run the power plant only if it is profitable to do so. In general, this situation will occur when: Power spot price > operating heat rate 3 natural gas spot price.

OPERATING HEAT RATE. The heat rate can be interpreted as the quantity of natural gas, measured in millions of Btu, that the plant operator must purchase to produce one megawatt-hour of electricity. In effect, the operator is guaranteed an operating profit margin for each megawatt-hour of electricity that a plant generates. The decision criterion adopted by the operator must be viewed in the following light:

Profit per MWh 5 power spot price 2 operating heat rate 3 natural gas spot price.

Conversely, the operator should choose not to run the generation unit if energy pool prices are not favorable, when revenue is less than cost: %n1%n Power spot