Hedging Strategy and Electricity Contract Engineering - IFOR

96 Contract engineering
period the owner has the option to transmit electricity from A to B whose
payoff is given by S B 1 K l › S A › œ . But the owner also has the option to
transmit electricity from B to A, whose payoff is given by S A 1 K l › S B œ .
Each of these options is called a locational spread call option. These types of
contracts are already traded in the Nordic market under the name contracts for
difference, 17 though not as options but as futures.
By owning such a transmission line we have the option in each period to exchange
electricity in A for B and vice versa at the cost of 1 K l . We can hence
conclude that a transmission line equals a series of locational spread options.
4.9. Real option theory
The traditional approach to value real assets, such as a power plant, is to use the
discounted cash flow (DCF) method. The expected future cash flows E C F t
are discounted at a risk-adjusted rate r a and integrated over the life time of the
asset t š T › to achieve the value of the asset
DC F
t
T
e«
r a´µ « t· E C Fµ dķž
The risk adjusted rate could typically be the equilibrium return derived from
the CAPM, introduced in Chapter 3.7.2. In many assets the owner has the
possibility to control these cash flows, since he has the option to pursue different
actions like postponing an investment or in our case to choose whether
to produce or not. The DCF method cannot take these options into account
[CA01] and hence assesses an incorrect value to the real asset. In fact, risk
is seen as something purely negative, since the discount rate increases with
risk, 18 whereas we know that flexible plants like the gas turbine benefit from
risky, i. e. volatile prices. It is hence clear that an approach is needed where
this flexibility, these built-in options are taken into account.
17 These contracts were introduced in Chapter 2.7.
18 Risk in the CAPM framework, for example, is given by the ¹ , determined by the volatility
of the asset’s return and the correlation to the market return.