Hedging Strategy and Electricity Contract Engineering - IFOR

98 Contract engineering
As seen in the example from Deng et al. [DJS01] our notion of contract engineering
is closely related to the real option theory. But whereas the real option
theory normally tries to value a real asset by valuing the corresponding managerial
options we have so far only derived the corresponding financial contracts
of the different plants, not valued these contracts. It should once again be mentioned
that it is very challenging to value such options in the electricity market
and the attempts so far rely on heavy assumptions, such as in the case of Deng
et al. [DJS01], where they assume that hourly futures are traded out on the forward
curve until the remaining life of the asset T , typically decades to avoid
the problem of the non-storability of electricity, and that the underlying price
process does not exhibit jumps. Instead, we will in Chapter 4.11 shortly describe
how a utility can internally price contracts through their corresponding
production plant.
4.10. Value of different production plants
The value of a power plant basically comes from the difference between the
electricity price and the operation costs. The price that the electricity on
average is effectively sold at depends on the flexibility of the plant. As shown
in Chapter 4.2 the gas turbine, for example, will sell electricity at a higher
average price than, for example, a nuclear plant. On the other hand, the gas
turbine will not generate a continuous cash flow to cover deprecations and
capital costs, but only run occasionally when electricity prices exceed marginal
cost of production.
Most technologies exhibit an inverse relationship between their capital costs
and generation costs. Base load plants typically have high capital costs and
low generation costs as compared to peak load plants, which have relatively
low capital costs and high generation costs [OEC98]. This is illustrated in
Figure 4.8, showing the proportionally much higher fixed costs for a base load
plant (nuclear plant) compared to an intermediate load plant (coal plant) and a
peak load plant (gas turbine) and vice versa for the marginal costs.
The plants that will survive in a deregulated market must either have low