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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 5 - EnergyCo Total NPV & EaR

Bid Price to Generate a $0 NPV.

A rational first step in determining the bid price would be to pinpoint the rate at which the deal would generate a flat net present value (NPV) of $0. This is the price you would have to collect per megawatt-hour to cover all the costs included in the commitment. The uncertainty in prices and customer demand likely would make the results higher or lower than this, but on average, the merchant could expect a balance between revenues and costs.

A Monte Carlo simulation model can be used to generate a distribution of load and price scenarios. Based on the analysis, a bid price of $52.96/MWh is determined to be the price at which this deal will expected to return a $0 NPV. Figure 7 summarizes the risk and distribution of outcomes for this contract.

Figure 6 - EnergyCo RAROC for 2005/2006 Operations

Although the NPV is $0 under this bid price, plenty of scenarios would result in a loss for this deal. In fact, there is a 5 percent chance that the loss will be greater than $8.56 million. The absolute worst scenario results in a $12.78 million loss. One would argue that the possibility of losses in this range requires the bidder to add a premium onto their bid to generate a positive expected NPV.

Step 2: Incorporate a Risk Charge into the Bid Price.

Before a risk charge can be determined, we must define the concept. The question to ask is, "What return must be realized in order to compensate the bidder for the risk they are taking?" The "risk charge" is simply a built in premium to the bid price to compensate for the cost of risk. One common approach is to take the total risk of the trade, in this case the Earnings at Risk (EaR), and treat it like investment capital.

Figures 7 & 8 - Load Serving Contract at $0 NPV; Load Serving Contract at $8.61 NPV

The level of return on risk capital depends on a number of factors including risk appetite, corporate strategy, alternative uses of this capital, etc. For illustrative purposes, assume EnergyCo requires a 100 percent return on every incremental dollar put at risk. In this case they would require a return of $8.6 million. Therefore, the bid price must be set at $62.79/MWh (almost $10 above the zero NPV bid price). At this price, the expected return would be sufficient to cover the required risk charge.

Step 3: Determine Bid Price Based on Incremental Risk Impact on Current Portfolio.

Recent load-serving auctions have been very competitive. It is likely that such a premium would not be accepted in a competitive market. However, any merchant with an existing portfolio could still benefit from a lower bid price if they consider how this transaction would impact the risk profile of their pre-existing portfolio.

If you add the transaction to EnergyCo's current portfolio, it reduces the overall portfolio's earnings at risk by $738,000. One can view that as releasing $738 of risk capital. As such, it is now possible to bid a price that actually returns a value less than zero. In this example, EnergyCo can now offer $52.30/MWh and maintain its