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Realistic Power Plant Valuations
How to Use Cointegrated Power & Fuel Prices.
By Henk Sjoerd Los, Cyriel de Jong & Hans van Dijken
T
he large investments in new power generation assets availability of the power plant meet expectations? Without
illustrate the need for proper financial plant evaluations. doubt, today’s expectations about future prices and plant
Traditional net present value (NPV) analysis disregards the performancewillprovetobewrong.Therefore,itisessentialto
flexibility to adjust production decisions to market developments, have a clear picture about potential price scenarios, likely
and thus underestimate true plant value. On the other hand, plant behaviour and future hedging strategies. This
methods treating power plants as a series of spread options ignore combination of variables provides a range of outcomes, which
technical and contractual restrictions, and thus overestimate true gives valuable insight in the total value distribution and the
plant value. In this article we demonstrate the use of cointegration optimal dispatch and hedging strategy to follow.
to incorporate market fundamentals and calculate dynamic, yet Inthisarticlewedescribehowtoovercomethemostcommon
reasonable, spread levels and power plant values. pitfalls in power plant valuation. We explain how a realistic
A practical case study demonstrates how various technical and Monte Carlo price simulation framework can be built in line
market constraints impact plant value. It also demonstrates that withamarket’smeritorder,usingacointegrationapproach.We
plant value may contain considerable option value, but 64% less also show how plant characteristics can be incorporated into
than with the usual real option approaches. We conclude with an this framework. This approach is especially relevant for assets
analysis of static and dynamic hedges affecting risk and return thatarerelativelyflexibleandlocatedinthebackofthesupply
profiles. stack. We will demonstrate that the extrinsic value or the
flexibility value for low efficient (gas) plants is relatively high
Power Plant Investment Needs but lower than traditional simulation and option pricing
Thecombinationofrisingelectricitydemandwithanageing methods may suggest. Finally, we clarify the impact of asset-
production park requires continuous investments in new backed trading strategies on actual cash-flows.
production capacity. Although countries worldwide have
ambitious targets for green energy consumption, fossil fired Intrinsic Valuation
power plants will continue to play a key role in the coming The gross margin of a power plant is determined by the
years. RWE estimates that only 400,000 MW of existing difference between the power price and the production costs,
capacityhastoberenewedinEurope,170,000MWofwhichis consisting of costs for fuel, CO
2
emissions and variable
from fossil-fired power plants. In the 2008 edition of operating costs. This margin is commonly denoted as (clean)
WorldPower the authors investigated investments in wind spark spread for gas-fired units and (clean) dark spread for
production (De Jong and Van Dijken, 2008). Whereas coal-firedunits.Dependingontheplantefficiency,theamount
investments in windmills will be massive, coal and gas-fired of fuel required to produce 1 MWh of electricity varies. A new
power plants will remain the backbone Combined Cycle Gas Turbine (CCGT)
of the world’s electricity production for
... coal & gas-fired power
with a 58%
1
efficiency requires 1.7 MWh
the coming decades and are the subject
of this article. This does not necessarily
plants will remain the
ofgas,whereasanolderunitwitha50%
efficiencyrequires2MWhofgas.Wewill
violate green energy targets, considering
backbone of the world’s
refertoallspreadsas‘sparkspreads’,not
the possibilities of replacing fossil fuels
electricity production
implying the discussion is limited to gas.
with biofuels and possibilities of carbon A traditional approach to determining
capture and storage. plant value is to calculate the future spark spread levels and
The need for investments may be clear, but each individual multiplythiswithaloadfactorofsay2,500hoursoff-peakand
investmenthastobejustifiedbeforeitcanactuallybemade.If 2,500hourspeakload.AnNPVisobtainedbydiscountingback

we assume that the price for a new gas plant equals around allsparkspreadstotoday,whiledeductingallcostcomponents
700 per kW, it’s easy to calculate that a 420 MW gas-fired and the initial investment. This approach is often combined
plant costs almost €300 million. Investments in coal-fired with a scenario analysis, where prices are assumed to be
plants easily involve a multiple of this number and these relatively high or low over the complete evaluation period.
investments have to be earned back over a plant’s lifetime. Asafirstimprovement,moredetailedforwardcurvesforthe
The difficulty with estimating future income is the relevant commodities should be constructed. Initially, the
uncertainty about price levels combined with uncertainty curves typically have a monthly granularity. Further out in
aboutassetbehaviour.Willpricesremainatthislevel?Willthe time,thecurveinevitablyinvolvessome(solid)guesswork.The
48 worldPower2009
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