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Efficient Frontier: A Brief Overview

The efficient frontier is a portfolio analysis concept designed to assess risk vs. return for an investment portfolio. 

Fortnightly Magazine - September 2005

The efficient frontier is a portfolio analysis concept designed to assess risk vs. return for an investment portfolio. While the financial projections of individual assets are key to the analysis, the end result is critical to successful structuring of the portfolio as a whole. Key to the efficient frontier is that it represents the highest level of a portfolio's return for any given level of risk. It can be applied to physical assets, as well as financial instruments—simultaneously. Figure 1 displays a typical efficient frontier chart. The horizontal axis represents risk (typically in the form of standard deviation of return in dollars), while the vertical axis represents return (typically in the form of the mean return expected of the portfolio). The line, which is the efficient frontier itself, represents the highest level of expected return for any given level of risk for any possible combination of assets for the portfolio. The area under the curve is populated by every other "non-efficient" portfolio that can exist.

Plotting a power generation portfolio is an extremely useful approach to understanding risk and return—and the power industry is well suited for it. For one, power markets are generally volatile—even in the long term. Recent poor financial performance by individual assets-and portfolios as a whole-has highlighted the need for more insightful approaches to asset acquisition and portfolio structuring.

Fortunately, some key elements of portfolio assessment exist for the power industry: access to powerful stochastic power market models, and both historical and projected data. These are critical in performing efficient frontier analysis, which relies heavily on stochastic inputs for individual returns. Moreover, since many energy portfolios consist of both physical assets and financial instruments such as contracts, the ability of the efficient frontier to consider both simultaneously makes it an excellent portfolio assessment choice.

By identifying the efficient frontier, energy investors have the ability to quickly assess their existing energy portfolios. Additionally, the outputs also are readily usable by other risk analysis and risk management tools, enabling more powerful decision making on asset utilization—such as how to market a power plant's output in the trading arm of the organization. Most of all, the efficient frontier provides the information upon which portfolio changes should be made. The information enables an energy portfolio owner to restructure its portfolio to be efficient-producing the highest expected return for any level of risk—by buying or selling the power generation assets that comprise an ideal portfolio.

As previously mentioned, data is critical in efficient frontier analysis. First and foremost, a stochastic projection of the cash flow from individual assets is required. This includes all of the existing assets in the current portfolio, plus projections for the potential new entrants to the portfolio. WS&Q develops this data with a generation dispatch model also known as a production cost model. There are many models currently available, but the model