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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

or physical asset because it is hard to store and hold indefinitely. The Black-Scholes formula cannot return a value greater than the current asset price (1.0), because this would mean the right to buy the asset is worth more than the asset itself, which is clearly nonsense. In such a case, the rational investor simply would purchase the asset today and hold it until needed. Therefore, care should be taken if a Black-Scholes calculation returns a large value (>0.7). In practice, most people try to minimize the current cost of insurance and select a ceiling price and time frame to balance their budget/insurance need ( e.g., people often will select a higher deductible, to lower their insurance premium/cost).

Numerous risks and factors outside of the four inputs to the Black-Scholes equation (current and future asset prices, volatility and interest rate) will affect each party’s willingness to reach an agreement. These include the trust of each party entering into the contract that the other can fulfill the terms. Will the wind farm be in operation in 10 or 20 years? Will the wind farm produce as much energy in 20 years as it does now? Will the buyer be in business in 20 years and still interested in purchasing electricity? Many markets devise screening (a minimum credit rating) or security requirements (a bond or risk adjusted margin deposit) that each participant must meet to be allowed to join and trade. Although providing such security initially limits the number of market participants and increases transaction costs, it builds confidence and reduces the risk of default. Another factor that could have a significant impact on call values is the limited liquidity or the ease with which a participant can enter or exit a position. These questions and problems are present whenever a market is in the early stages of development and can be resolved, but they will have an effect. Often, these concerns can influence the price that parties are willing to offer or accept. A Black-Scholes call valuation can offer a starting point for such negotiations that necessarily will be affected by supply and demand for energy price insurance, along with many other factors. 2

Call Buyer

Electricity users concerned about future electricity price volatility would be interested in buying protection each year that they can. In this example, we have a user that wants to insure that its future electricity costs do not go above twice its current cost (10 cents/kWh) for the decade starting 10 years from now. If we assume 15 percent volatility, we can use the second column of Table 2 to understand how much this protection would cost. The values in the first three rows of the second column of Table 2 are 0.12, 0.25, and 0.38; if we add these values and divide by 3 we get 0.25. This means it will cost on average 0.25 times current price (= 2.5 cents/kWh) each year to cap costs at 20 cents/kWh. In total, it will cost 25 cents/kWh to insure that future electricity costs do not exceed 20