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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

cents/kWh for the decade of 2016 to 2025.

If we assume prices rise 5 percent a year, then by the end of the 14th year prices will have doubled. See the middle two retail price curves (green lines) of Figure 3. In year 15 the call buyer will exercise the call option and only pay 20 cents/kWh for the remaining years. The buyer “saves” a cumulative 21.4 cents/kWh during the last years of the contract. Like a home owner who buys flood insurance, if the buyer’s basement floods, the insurance company pays the claim. The call-option buyer paid out more than he recovered, but got peace of mind and benefited from the price cap.

Price doubling and 15 percent volatility over a 20-year time frame may represent an aggressive scenario. Yet almost the same result (in terms of call premium) would be obtained if volatility was only 7.5 percent and the call buyer wanted to cap prices 65 percent above the current price for the same decade. In this reduced volatility world, one would see annual price increases of 2.6 percent (zero payout, calls never exercised), 3.8 percent (recover about half of premium paid), and 5 percent (1.6 times initial premium recovered).

Call Seller

How might a renewable plant operator benefit from selling call options? Take a 50-MW wind farm with the following operational data: 3

• Capital cost: $50 million ($1,000/kW);
• Annual production: 150 million kWh—35 percent capacity factor; 4 and
• Annual Revenue: $6 million, assuming 4 cents/kWh wholesale price.

We assume the operator sells call options at twice the current wholesale price for the decade beginning in 2016. We further assume that electricity price volatility is 15 percent. In the previous example we saw that this call option will cost on average 25 percent of the current price. Using the 4 cents/kWh current price, we see that the wind farm operator could make 1 cent/kWh for selling electricity insurance that caps the price of electricity at 8 cents/kWh for the decade 2016-2025.

If the wind farm operator sells calls on 80 percent of its annual production:

• 80 percent of annual production = 120 million kWh = 0.8 x 150 million kWh;
• Call revenue for each year = $1.2 million = 120 million kWh x 1 cent/kWh; and
• Call revenue for the decade = $12 million = 10 years x $1.2 million/year.

Thus, in this example, by selling one decade’s worth of electricity price insurance today, the wind-farm operator could recover $12 million, or nearly one-fourth, of the wind-farm operator’s capital cost.

The call seller “pays” for this premium if prices more than double. In this example, the operator gives up 80 percent of revenue above 8 cents/kWh for the contract decade. This lost revenue can be clearly seen in Figure 4 by comparing the solid line (no call selling) with the dashed line (with call selling) of the same color. For either the 3.5 percent or 5 percent annual wholesale price inflation case, the call seller clearly benefits (generates more total revenue) by selling calls.