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Spark Spread Options: Linking Spot and Futures Markets for Gas and Electricity
price , operating heat rate 3 natural gas spot price.
The operator's ability to decide whether to run his units shows that the power plant has the characteristics of a real option. To clarify the option concept, let Pe be the spot price of electricity in dollars per MWh; let Pg be the spot price of natural gas in dollars per MMBtu; and let HR be the plant operating heat rate, expressed in MMBtu per MWh, then:
Equation 1. Plant Profit (as a function of heat rate and spot prices for electricity and gas)
Profit per MWh 5 Pe 2 HR 3 Pg
As presented, the profit margin is the spread between the sale price of electricity and the fuel cost incurred by the plant operator to generate that electric energy. The operator will take advantage of the positive electric energy and natural gas price spread and "strike" the transaction by selling power at Pe and buying gas at Pg, earning a profit. %n2%n If the spread is not favorable to the operator, he stays put and does nothing. In effect, the owner-operator is holding a call option that allows him to bid the capacity of some unit within a specific period. Underlying the option is the energy prices Pe and Pg, as well as the conversion efficiency of the generation unit.
SPOT MARKET HEAT RATE. As in all commodity markets, whether agricultural, metal or energy, the definition of a spot market is essential for participants who are either speculating or hedging. For our applications we define the spot market as the prompt-month futures contract.
For the Southern California power pool region, the spot market for electricity can be the New York Mercantile Exchange prompt-month futures contract at Palo Verde, Ariz., at expiration. The spot market for natural gas is the California-Arizona border bid-week trading plus charges imposed for local distribution. %n3%n
Since the plant operator is familiar with the heat rates of his units, the spot market heat rate, or MHR, may prove a more informative indicator. The MHR ties together the market clearing prices of electric power and natural gas, and suggests the efficiency of units that are run at the margin during peak periods. The MHR is derived as follows:
Equation 2. Spot Market Heat Rate (plant efficiency in terms of current spot prices for electricity and gas)
MHR 5 Pe 4 Pg
The plant operator can now compare his operating heat rates with the spot market heat rate, which reflects the energy conversion efficiency of the market. His decision to generate power depends on whether the MHR is greater than his unit operating heat rate. If the MHR is greater, the operator makes a profit by purchasing natural gas and selling the electricity that he generates. In other words, the unit is "in the money." By substituting Equation 2 into Equation 1, and by rearranging the terms, the profit margin per MWh becomes the difference between the spot market heat rate and the plant operating heat rate:
Equation 3: Plant Profit Margin (the difference between market-reconciled and operating