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

Fortnightly Magazine - March 15 1998

This translates to a price of $2,760 per MW (or $7.50 per MWh for 368 on-peak hours). The power marketer could realize as much as, if not more than, $600 per MW if the utility operator signs the proposed deal. The utility would have left about 20 percent of the money on the table. In sum, the BS pricing model has provided an indication of what the spark spread call option may be worth in the marketplace. However, actual transaction prices in an illiquid market still depend on the relative acumen of the negotiating parties.

Michael Hsu is senior analyst at Edison Enterprises. He is also a doctoral candidate in the Engineering Economic Systems and Operations Research at Stanford University. Nguyen T. Quan, Ph.D., teaches at UCLA Extension and is a principal at N. T. Quan and Associates, an economic consulting firm in Los Angeles. The authors thank Edward Kahn, Ph.D., and Robert Michaels, Ph.D., for their helpful comments. A more technical and detailed treatment of these concepts, written by the first author, "Spark Spread Options Are Hot" appears in the March 1998 issue of The Electricity Journal.

1 The plant operator also must consider various costs (e.g., start-up costs, no-load costs) and operating requirements (e.g., start-up time, minimum shut-down time and ramp rates) before bidding his units into the market place. When the operator runs multiple units, he should also consider portfolio impacts (e.g., one unit providing reserve requirement for another).

2 Using the nomenclature of options, the operating profit per MWh, or the payoff, is written as: Profit per MWh 5 max(Pe 2 HR 3 Pg, 0).

3 On the wholesale market, natural gas price is expressed in terms of dollars per MMBtu, while electricity contracts are valued in dollars per MWh. Note that when a futures contract is taken to physical delivery, the delivery period is over the entire month.

4 One NYMEX electricity contract calls for 2 MW to be delivered for 16 on-peak hours each day for 23 days, totaling 736 MWh over the entire month.

5 In other words, electricity and natural gas prices do not follow a log-normal distribution as assumed by the BS approach, rather they revert to a long-term mean value, possibly driven by production cost. Also, critical to the BS valuation formula are the volatility of prices and correlation between them, which should be forward looking rather than statistically determined from historical data.

6 Many financial software programs can evaluate BS option models. We use a program aptly called the Positron Energy Pricer.

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