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Green Options On the Future

Call options can be used as a financing tool for fixed-cost renewable energy technologies.

Fortnightly Magazine - August 2006

An unexploited benefit of renewable energy is the predictability of operating costs over the long term. A renewables operator knows today how much it will cost to produce energy decades in the future. This future price certainty has a value that can be transferred to electricity buyers or other market participants.

Long-term call options, akin to electricity price insurance, can capture some of this value. Short-term call options—options that expire in three years or less—are traded commonly on numerous markets. These include options on energy inputs commodities like coal, oil, and natural gas, as well as energy products, like electricity.

How much value can a renewable-plant operator capture from selling long-term call options, given several future price and volatility scenarios? What will be the cost and benefit to an individual buyer or seller?

Knowledge of Future Costs

Most renewable energy plants require a large upfront equipment and installation cost, followed by smaller, predictable annual costs for operations and maintenance (O&M). To the extent that O&M costs are predictable, a plant operator knows today what it will cost to produce electricity in 10, 15, or even 20 years. This is quite remarkable and valuable information. By contrast, more than 90 percent of the electricity industry does not know its costs beyond a year or two into the future because of the price volatility of fossil fuels.

Energy markets (including electricity) are complex and volatile, with numerous suppliers, inputs, technologies, and other factors that affect electricity prices.

Given current technology, the grid operates best when there is a balance between supply and demand. “Load balancing” is challenging because electricity is difficult to store. The current electricity derivative markets have focused on meeting this challenge.

Market participants are interdependent. Each faces varying degrees of regulation and constraint. Regulation can determine which participant within a given supply chain bears the burden or cost of volatility. Changes in regulation can shift the burden around, but cannot eliminate volatility.

One notable constraint within the North American electricity market is limited transmission capacity among regions. This creates multiple independent regional markets. Also, the U.S. electricity market has been segmented by regulation so that different users pay different prices for the electricity used ( i.e. residential, commercial, and industrial rates). Electricity users often respond only after the fact to price signals ( i.e., after customers get their monthly bills) if at all. Taken together, all these factors contribute to a complex, volatile marketplace.

Electricity Price Insurance

How do you capture the value of cost certainty? A good way would be to sell electricity price insurance, in the form of long-term call options. A call option gives the buyer the right (but not the obligation) to buy the asset at a fixed price at a fixed time in

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