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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 9 - Bid Price Summary

current return-over-risk ratio. In this case, the expected net present value is estimated to be a loss of $738,000.

Step 4: Use Portfolio RAROC for Setting Bid Price.

While the overall portfolio's risk in the previous price has been reduced by $738,000, the RAROC increases from 5.66 to 5.68. In other words, by executing this trade at an expected loss, EnergyCo has actually maintained its NPV and improved its risk/return profile.

If the organization wants to be even more competitive in its bid for this deal, it could offer even lower rates and maintain its risk/return profile. It could generate a loss of $4.2 million on this trade and maintain the original RAROC of 5.66. This would allow the bid price to be as low as $48.19/MWh and still maintain the 5.66 RAROC. This gives the bidder enormous flexibility in acquiring more business.

The analysis presented in this article illustrates the volumetric and price risks that should be incorporated in the potential bid price for load servicing contracts. We use Monte Carlo simulation to estimate a range of bid prices as low as $48.19/MWh and as high as $62.79/MWh. This highlights that risk and the existing portfolio of a bidding organization have a material impact on the determination of the proper bid price for any transaction, especially load servicing.