Public Utilities Reports

PUR Guide 2012 Fully Updated Version

Available NOW!
PUR Guide

This comprehensive self-study certification course is designed to teach the novice or pro everything they need to understand and succeed in every phase of the public utilities business.

Order Now

Spark Spread Options: Linking Spot and Futures Markets for Gas and Electricity

Fortnightly Magazine - March 15 1998

a position in the market, the utility still holds the option of not generating and "unwinding" the futures contract by selling the gas it had purchased, and buying back the power to fulfill its generation obligation.

Suppose the August spot prices turn out quite different than projected in the futures market: at $20 per MWh (lower) and $2.50 per MMBtu (higher) for electricity and gas, respectively. These new prices imply a spot market heat rate of 8 MMBtu per MWh, which is less than the operating heat rate of the unit under negotiation. If the utility chooses to generate under this scenario it will receive the profit margin as specified by the futures transactions executed in February. However, the utility could earn an additional profit by shutting down the power plant in August. This profit is achieved by performing the following two transactions:

1. Buy electricity at the spot price to fulfill the NYMEX futures contract obligation. The cost of purchasing electricity on the spot market in August is about:

300 MW 3 368 on-peak hours per month 3 (2$20 per MWh) This transaction on electricity contracts produces a profit of $660,000 for August:

$2.87 million 2 $2.21 million 5 $660,000

2. Sell the gas purchased from the futures contract. The gas is worth on the August spot market:

The sale of gas on the spot market offsets the $2.21 million cost incurred in the purchase of gas futures, resulting in a $550,000 profit for August. Therefore, the total profit for shutting down the power plant and unwinding the original energy contracts is $1.21 million or $4,034 per MW. The choice of not generating when spot prices are considered "unfavorable" resulted in doubling the utility's anticipated profit per MW.

The key conclusion to draw from this example is that spot prices, rather than long-term contracts, dictate the dispatch of power plants. If the market heat rate is higher than the unit's operating heat rate then generate, and if it is lower, then shut the unit down.

In sum, the operating decision is independent from any financial contracts and/or physical obligations entered previously.

The example above shows that the utility is able to extract additional dollars from the generation unit greater than the $2,160 per MW quoted by the power marketer. Thus, it is reasonable to presume that the unit is "worth" more. But how much more? The BS option pricing method is a good starting point for determining that additional worth.

The value of a spark spread call option consists of its intrinsic value and its "option" value, which is driven by the uncertainties of the underlying energy prices. The power marketer's proposed $2,160 per MW or $5.87 per MWh is equivalent to the intrinsic value of the option, an amount that the utility can lock in today.

The BS pricing formula gives the total worth of the spark spread call option, including both the intrinsic and the "option" components. Therefore, using the parameters noted above, the spark spread call option maturing in 6 months is worth about $7.50 per MWh. %n6%n