Rethinking Asset Values in a Competitive Environment
Power plants can bid on more than one product. That's why most spark-spread studies miss the mark.
Forward energy prices can make it look easy to place a value on a power plant. Yet something is missing. Plants can sell more than one product. One price may be up while another is down. As Einstein said, a theory should be as simple as possible, but no simpler.
That is why it is worth reexamining the methods commonly used to calculate forward price curves and estimate the expected revenues and profits of generating assets.
First, do the relevant calculations include all products that the asset's revenue will depend upon? Do they meaningfully incorporate those rare events having large price effects over an extended time horizon? These questions go to the heart of whether a method is either appropriate or adaptive to asset valuation in the future electricity market.
When the forward price curve is focused solely on energy, the assumption is made that generators would passively accept whatever price the forward energy market offers, exclusive of other markets. In practice, a generator operator will seek to maximize income by seeking profits and advantage across all available markets. In order to reveal the full earnings potential of the asset, valuation must also include the revenues that operators might earn by participating in the lucrative ancillary service and spot markets. The price risk that characterizes power markets is too considerable to suppose that market participants will not continuously compare the levels of profit potentially available in the various product markets.
Black's Model: Not Practical for Multiple Bids
The most commonly used method to analyze forward prices is relatively simple in concept. To determine the earnings potential of a base-loaded unit like a combined cycle (CC) unit, the NPV (net present value) of the spark spread (the difference between the forward price and the variable operating cost of the unit) is calculated and aggregated over its lifetime. For cycling units like combustion turbines, the calculation is similar to that used for the CC, except that an annual price duration curve is occasionally used to capture the cycling behavior of the unit. The price duration curve allows a quick appraisal of those hours during which a CT can and should profitably operate; a CC is assumed to serve base-load capacity at all hours, less those lost to outages, due to its lower costs. In either case, the method by which the forward price curve is obtained is the key to the investment decision.
In attempts to develop forward price curves, some projections use an analysis based on a type of Black's model, used to value options. That can prove wanting, however.
While the past may be used as a guide to the current behavior of standardized commodity prices, the electricity market is distinguished by its current evolution and its tremendous short-term, intra-hour volatility. Historical methods lack justification in that they do not meet the two conditions put forth earlier - inclusion of potential revenues from multiple products and markets, and incorporation of rare events causing price spikes.