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BGS Auctions: What Price Is Right?

How to price new load-servicing contracts while incorporating market-risk analysis into such deals.

Fortnightly Magazine - June 2005
Figure 2 - Native Postion Summary - Electricity

of monthly imbalance that is expected for EnergyCo. While Apr. '06 and Sept. '06 are two examples of a balanced month, there is still a significant level of risk that the balance could be off by more than 500,000 MWh. Many of the other months have potential imbalances up to twice that level.

Extending the Forecast

This analysis can be extended to generating a comprehensive set of correlated net earnings forecasts. For example, EnergyCo can take the volumetric forecasts discussed above, plus a set of corresponding power and fuel price simulations and related operating costs to arrive at the earnings forecast. Figure 4 illustrates an example of a set of simulated spot-power prices during July 2005.

This analysis allows EnergyCo to forecast a net operating income of $1.2 billion ($659 million in '05, $555 million in '06) during the next two years. They also have estimated $203 million in earnings at risk (expected earnings less the 5 percent worst-case earnings). Figure 5 summarizes the results of the simulation analysis.

RAROC

Figure 3 - Net Overall EE Position Including All Generation Load and Energy Trades

EnergyCo now understands its expected earnings and risk. These measures can be combined to generate a RAROC. The benefit of this is that RAROC allows for risk/return comparisons across different business lines. The enterprise-wide earnings forecasts summarized above can be generated for individual business activities. If we isolate these business lines we can generate a RAROC for each. Figure 6 summarizes the expected earnings, worst-case earnings, EaR, and RAROC for EnergyCo's three activities. When comparing each activity, it is clear that generation is the most attractive because it has the highest RAROC (1.97). However, there is another benefit to these other activities. They are risk reducing when aggregated with generation. This combination improves the RAROC of generation from 1.97 to 5.97 for the total enterprise.

EnergyCo is now armed with all of the tools it requires to price new trades or load-servicing commitments. Given its simulated forecasts for its current portfolio of exposures, it is in a much better position to understand its needs for additional trades. By layering on the simulation results of a contemplated trade, the organization can review the trade's overall impact on its net position.

For the purposes of illustration, suppose EnergyCo has the opportunity to enter into a load-serving contract for 115 MW of additional load (0.924 million MWhs over two years). However, it is a competitive market subject to bids from multiple merchants. EnergyCo must make a competitive bid that is low enough to compete with the market.

Figure 4 - Simulated On Peak Prices – PJM West July 2005

What should the bid price be?

Pricing is complicated. The merchants needs to incorporate the market price as well as a range of pass-through costs. For example, any merchant bidding on the BGS auction must include the following costs in their bid price:

  • Transmission losses;
  • Capacity and FERC charges;
  • Green costs;
  • Operating reserves - real-time and day-ahead;
  • Reactive supply and voltage control;
  • Regulation and frequency response;
  • Transitional market expansion;
  • Transmission charges; and
  • Transmission owner schedule/control dispatch service.

In addition, there is a price risk and volumetric risk that should be incorporated into the bid.

Step 1: Determine the