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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

the future. The seller agrees (for a price) to cap the user’s future electricity cost. The electricity buyer now has a ceiling on future electricity costs, while the seller of the call option gets paid today for providing insurance. Both buyer and seller obtain a clear benefit.

Different renewable energy technologies produce electricity with different costs (peak vs. baseline). Moreover, peak costs may change at a different rate than baseline costs. So the type of energy supplied will affect what electricity cost a call seller can insure against. Also certain buyers in some regional markets will gain more value from a call option than will other buyers. All these factors should be considered when matching a call buyer and seller.

Setting a price for long-term call options is challenging. The price will depend on how these factors vary over time, and on each party’s:

• Risk tolerance;
• Views and assumptions about inflation;
• 10- to 20-year forecasts for electricity supply and demand; and
• Assumptions about energy prices decades hence.

Since no reliable way exists to predict these items even from one year to the next, there is obviously no way to do so over a period of decades. The Black-Scholes options valuation method provides a ballpark estimate of the option value. The method allows one to price the risk of future events, such as an asset rising or falling in value. As noted above, options and futures already trade for most fossil fuels and even for electricity on a time scale of hours and up to a year or two in the future. Using the Black-Scholes method and longer time scales, we can estimate the value of long-term electricity price call options.

For this purpose the relevant inputs to a Black-Scholes calculation are:

• current asset price—present electric rate per kilowatt-hour;
• future or ceiling price of the asset—the buyer’s future price cap;
• expected electricity price volatility—usually based on historic volatility;
• years to option expiration; and
• risk-free interest rate—frequently the 10- or 30-year U.S. Treasury rate.

To quantify the potential value of these long-term options, let’s select some values for these key variables. We assumed a 5 percent risk-free interest rate (a higher rate will increase call value). The time to expiration is important in valuing a call option. We will look at the value today based on several different expiration periods: 10, 15, 20, and 25 years into the future. The value of the call increases as the time to expiration increases (all else held constant).

For two main reasons we use options that expire in 10 or more years. First, call options that expire sooner are worth less than options covering more time. Second, many renewable electricity producers enter into 10-year power purchase agreements (PPAs) to sell all production to their local electricity utility. Investors basically demand these agreements because they guarantee a market exists for the power the plant will produce. In proposing a new financial tool, we think it makes sense to propose one that works with (or around) such existing and proven