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Power Measurements

Energy trading returns, healthier and wiser.
Fortnightly Magazine - August 2004

plant well "in the money" maps to peak and off-peak forward contracts. However, mid-merit and peaking generation is more difficult.

If we analyze a generation asset through a Monte Carlo simulation model (such as Global Energy Decision's EnerPrise software) to identify the potential cash flows from the asset under price uncertainty, we see a significant distribution of values.

Unfortunately, the distribution in today's market is highly skewed, with revenues under the expected price streams toward the lower end of valuations. In many cases, this means the plant is not expected to run under the base case, but there is some probability that prices will increase and the plant will earn significantly higher revenue. Another way of looking at this is to break the generation asset down into its tradable components of forward contracts and option contracts.

When the asset is deep in the money (likely to run), it can be hedged with a forward contract. The hedge can be placed once. This can be equated to the intrinsic value of the asset. When it is out of the money it can be hedged only by an option. This is the extrinsic value. Unfortunately, the extrinsic value for many generation assets is significant, and the relationship between the two values continually changes.

What about these same value components for a combined-cycle plant?

Intrinsic and Extrinsic Values Per Year

A significant portion of the value is extrinsic (see Figure 3). Because of the skewed distribution, without option hedging only the lower value likely will be captured. A trading floor allows you to go after the rest. Henwood/GED has evaluated all the individual combined-cycle plants in its and estimates that the extrinsic value of these assets is $17.6 billion.

So where is this value going?

In a perfect market, this value will be captured in the supply chain from generator to customer, resulting in higher profits, lower prices, or both. In an inefficient market it will be lost. Combined-cycle plant will not be able to sell this option, and the retail suppliers will source it from alternative higher-cost sources (by maintaining their own inefficient peaking fleet, for instance).

The current market mixes both of these situations. Capacity markets are one form of these option markets, but they are far from perfect hedging tools. Vertical integration is another, but again, there can be significant inefficiencies if you use only your own portfolio to capture this value. Significant regulatory issues also must be considered.

With so many new combined-cycle plants having little intrinsic value in the short run, this extrinsic value is probably the highest it has ever been in the history of the U.S. power market. So what has this got to do with trading?

Trading and risk management is all about dealing with this type of uncertainty and complication. Instead of hedging once and going home, the hedged position should be re-evaluated each day. Every time the forward market or associated volatility changes, the components need to be separated out and the position re-hedged. To do this requires traders and systems.

The extrinsic asset value