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Rethinking Asset Values in a Competitive Environment

Fortnightly Magazine - February 1 2000

The period in which energy was a monolithic product is past. Recently, the California Independent System Operator (ISO), plus ISO-New England (the former NEPOOL) and PJM Interconnection LLC, have established more clearly than ever before a distinction between energy, ancillary services and reserve capacity products. These new product markets, as well as the spot markets in energy, offer alternative sources of revenue to the forward energy market. Their prices will depend on the energy market, and vice versa, with the exhaustion of arbitrage opportunities acting nominally, at least, to constrain unlimited inter-market basis differences.

By contrast, the historically derived analyses are necessarily based on scant data and are faced with a lack of liquidity in multiple markets. Black's model, to incorporate ancillary services, would require analyzing liquid futures in multiple commodity markets, not just those in energy. Moreover, those commodity prices and quantities that would characterize liquid energy and ancillary services markets would be highly correlated, whereas Black's model is not capable of application across multi-product markets.

Price Spikes: Not Captured

in Most Methods

As concerns price spikes, an historical model can not capture the supply-demand equilibrium in electricity that forms instantaneously yet changes continuously, and so introduces the characteristic volatility of spot or imbalance prices. (Given the variety of factors that affect electricity prices, even the spark spread, or basis difference between prices of gas and electricity, fluctuates with unpredictable frequency and magnitude.) The factors behind price spikes, and the concurrence of extreme, unpredictable events in terms of precise weather, system outage patterns, and/or demand conditions are not likely to follow historical occurrences. Thus, deriving a future dependency through regression is full of uncertainty, and invites the superposition of one source of volatility upon another.

An alternative to the historical approach merits attention, for the strengths it offers in the same areas in which historical projections suffer their most serious weaknesses. A Multi-product, Multi-area Optimal Power Flow (MMOPF) model with real-time dispatch is a structural model that incorporates generation, load and transmission data into a dynamic simulation. Such a structural model is required to simulate the hourly price fluctuations, and to ascertain how the uncertain distribution of the fundamental price drivers affects the price distributions among markets. (A description of such models can be found in "Forecasting Energy and Ancillary Prices and Asset Evaluation," a monograph published by my company, LCG, Los Altos, Calif.) An MMOPF model performs these analyses by its fusion of the technological characteristics of plants, their operational choices and market eligibility, and by incorporating the system constraints that affect the real-time dispatch of generating units. Fuel prices, demand fluctuation and emergency outages are some of the elements that are combined with overall system conditions within a structural model.

As for the introduction of new technologies, valuation with a structural model also can project the actual market participation by a unit, given its relevant characteristics and bid parameters. The range of product markets available to combustion turbines is especially broad, and thus, ancillary services will make up a relatively larger portion of overall revenue than they will for