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An effective tool for policy-makers, utilities and stakeholders.
Fortnightly Magazine - March 15 2003

An effective tool for policy-makers, utilities and stakeholders.

Renewable energy technologies, which do not require fossil fuel to generate electricity, promote power price stability by avoiding the risks associated with underlying natural gas price escalation, volatility, and delivery. A proxy for this hedge-value can be estimated by quantifying the costs faced by gas-fired generators in order to secure reliable natural gas supplies at a fixed price. These costs include direct expenses that must be paid by gas-fired, combined-cycle plants to: (1) guarantee gas delivery; and (2) eliminate price volatility and remove price escalation.

Where available, underground storage, with rapid injection and withdrawal capabilities, and located near the plant, is often the best and least-cost method to provide guaranteed gas delivery. Although the cost of storage varies considerably and is based on storage field economics and generator usage patterns, we find that average costs typically fall in the $0.50/mmBtu range. For a new combined-cycle, gas-fired generator with an aggressive heat rate of 7,000 Btu/kWh, this translates into an incremental generation cost of approximately $3.50/MWh.

Gas price volatility and escalation can be addressed through the use of financial options. An options strategy called a "collar" can be used to lock in a fixed price of gas, thus removing both volatility and escalation. This is done by buying a "call" option (which provides the buyer with the right to buy gas at a particular price) and selling a "put" option (which provides the seller with the obligation to sell gas at a particular price) with the same "strike" price for every delivery month. The cost of this strategy can be estimated using a relationship called the "put-call parity," which states that the net premium of a put and a call with the same delivery date and strike price is equal to the commodity price at the time of purchase, less the strike price discounted by the risk-free rate from the purchase to the delivery date. Of course, the cost of this risk management strategy is a function of future gas price expectations. Using a gas price forecast in which gas prices are expected to average $3.54/mmBtu (in real dollars) through 2020, we estimate that the incremental cost of enacting a collar strategy to hold fuel costs constant over the life of the plant is $2/MWh.

If we add the costs associated with meeting deliverability requirements through the use of gas storage and the cost associated with fixing future gas prices using options, we arrive at $5.50/MWh. This value represents a proxy for the value of the physical hedge provided by renewables. We note, however, that the costs associated with mitigating gas price escalation, price volatility, and ensuring reliable gas delivery are plant-specific and a function of geography, regional market dynamics, and future expectations. Further, the value of renewables as a hedge against fossil fuel price risk is only one component of the total renewable energy risk-return proposition. In the end, a comprehensive valuation approach that considers the full risks and rewards of both renewables and conventional generation investments is the only way to determine the