Hedging Strategy and Electricity Contract Engineering - IFOR

4.9 Real option theory 97
The science concerned with valuing real assets by taking these options into
account is called real option theory. The tools to value managerial options in
real asset are closely related to the tools used to value financial options. 19 The
similarities arise because the ability to control or manage a cash flow stream
represents an option. Another important similarity is according to [BT00] that
equivalent martingale pricing techniques, as in equation (3.6), are appropriate
to both real and financial options. The major difference, on the other hand,
is that while financial options are almost always options on traded assets,
the rights to controllable cash flows typically cannot be reduced to claims on
traded assets. As [BT00] note, the determination of the risk neutral probability
measure therefore is more complicated than is the case for financial options.
In the case of power plants in a liberalized market these controllable cash
flows can however theoretically be reduced to claims on traded assets, namely
futures and options on electricity as shown in this chapter. Because of the
incompleteness of the electricity market one however does not get much
guidance on how to choose the risk neutral probability measure, as discussed
in Chapter 3.7.1.
Deng et al. [DJS01] gives an example on how a gas turbine can be assessed
by valuing the corresponding spark spread options. By assuming that the
start-up and shut-down times are short and that the facility’s operation and
maintenance costs are constant, they state that the value of º the plant gas is
º
T
given by gas t›
0
C dt, t› where C is the value of a spark spread option
with expiration at t and with the corresponding characteristics of the plant,
namely p max and H, and T is the remaining life of the plant.
In the same manner they show how a transmission asset can be assessed by
valuing the corresponding locational spread options. Let C t› A» B be the value
of a locational spread option between location A and B with expiration at time
t. Let further A t› C B» be the value of an locational spread option between
location B and A with expiration at time t, both with the characteristics of
the specific transmission asset, namely its maximum power capacity and
transmission losses. The value of a transmission line connecting A and B
with a remaining lifetime of T is then º
T
given by tr 0 C t› B C A t› B» dt.
A»
19 See Chapter 3.7 for an introduction to the valuation of options.