Hedging Strategy and Electricity Contract Engineering - IFOR

6.4 Modeling of plants and their operational flexibility 121
price, exercise flexibility, volume flexibility and interruptability for the contract
portfolio. The marginal cost of a plant, as already mentioned, corresponds
to the strike price of an option, and the availability of a plant corresponds to
the interruptability of an OTC contract. Before the production portfolio is
optimized we identify the contracts corresponding to each plant, which we
call contract engineering. By doing this we can more easily compare the
production and the contract portfolio and derive the optimal dispatch strategy
for the different plant types. The power portfolio optimization problem is very
tractable from an academic point of view, since the engineering skills and
ways of thinking are needed to understand the production portfolio, whereas
financial thinking and skills are needed for the understanding of the contract
portfolio. The return of a power portfolio is affected by four major sources
of uncertainty; spot price, demand in swing options creating volume risk,
inflow into water dams adding production output uncertainty and fuel prices
for thermal plants causing production cost uncertainty. The importance of
the fuel price effect on the profit and loss should not be underestimated. For
example, PowerGen [plc92] attributes almost 70% of their operating costs to
fuel. Further fuel prices are volatile, in 1974 oil prices quadrupled and doubled
in 1979. Derivatives of oil, like natural gas, followed a similar pattern.
In general we will assume that the time, over which we study profit and risk
corresponds to K periods, where the length of each period is given by the length
of the spot contract, typically one hour.
6.4. Modeling of plants and their operational flexibility
For some plant types it is trivial to find the dispatch strategy making full use of
the operational flexibility, for other plants it is however a complex task. Before
we investigate this strategy for the most challenging plant, the hydro storage
plant in depth, we as an introduction shortly discuss the strategy corresponding
to the other plant types.