An Allegory of Uncertainty for Base Load Generation

Applying real options theory could bring salvation.

Investment in U.S. base load generation is risky business due to uncertainty in energy prices, carbon policy and regulatory oversight. Demand for electricity continues to grow, reserve margins shrink, and yet announced investments in base load units are cancelled or delayed. Tightened supply exacerbates price volatility, while political and regulatory activities increase risk to generation investments without promising the requisite returns. With so many mixed signals, industry participants may feel as if they are part of Dante’s “Divine Comedy,” alternating among the 13th century canticas of heaven, hell and purgatory.

Within this saga, how can utilities make long-range plans to meet demand? If regulatory assurances are not enough, real options theory may unlock investment in base load generation.

The Inferno of Uncertainty

The federal government has yet to produce a clear policy on carbon emissions, while state officials are filling the void. Last fall, the district attorney of New York issued subpoenas to investigate whether certain energy companies in the state had disclosed financial risks associated with planned coal plants. Around the same time, the secretary of health and environment in Kansas rejected a plan to expand an existing coal-fired power plant for health reasons related to carbon dioxide emissions. When the U.S. Environmental Protection Agency claimed carbon emissions were not a pollutant, the Commonwealth of Massachusetts challenged this assertion all the way to the Supreme Court; the Court determined that such emissions indeed are pollutants and therefore subject to EPA oversight. Meanwhile the U.S. Congress continues to debate possible federal legislation containing mandatory caps and the administration advocates approaches that do not involve caps. Policy uncertainty and its potential impact on profits continue outside investor control.

Add regulatory risks. Utilities are testing whether public utility commissions will allow rate recovery of new generation investment. Even if such investments are included in rates, however, a regulatory body, legislature or judiciary may perform a subsequent review and claw back returns on investments. Fledgling capacity markets in the eastern interconnect, intended to reduce financial uncertainty for generation investment, are under assault by consumer groups and some state regulators, undermining investor confidence in these markets.

Add market risks. Electricity and fuel inputs are volatile commodities. Separately traded power generation characteristics such as renewable energy credits (RECs), generation information system (GIS) certificates, and emissions permits are priced by market forces. In the world of electricity generation investment, the only certainty is uncertainty.

Waiting in Purgatory

In response to this uncertainty, investors in operationally inflexible base load generation technology are finding flexibility with real options in the project pipeline. They are cancelling projects, deferring projects, scaling back on projects, and in some cases, incurring the upfront investment to propose new projects only to have them sit in the project pipe-line indefinitely.

Figure 1: Cancellation/Postponement of Base Load Generation Projects Cumulative Capacity since 2000 by Fuel Type
Source: Energy Velocity data as of April each year, CRA Analysis
Click here to enlarge image

Figure 1 shows the capacity of U.S. base load generation projects initiated since 2000 (as recorded by Energy Velocity) that have been cancelled or postponed by fuel type as of April of each year. This chart shows that approximately half of the 625,000 MW summer capacity proposed since 2000 has been cancelled or postponed. Only one-quarter of the proposed capacity has gone into service. The other 25 percent is either proposed, application pending, permitted or under construction.

Each project pipeline by fuel type provides deeper insight. Natural gas combined cycles experienced a significant increase in proposed capacity from 2000 to 2002, followed by a significant number of cancellations. At the same time, proposed projects decreased precipitously (Figure 2). Operating projects leveled off by 2006, at which point the pipeline of new projects narrowed to less than 40,000 MW of summer capacity versus the high of 300,000 MW in 2002. The pattern corresponds to high increases in natural gas prices that appeared to make other base load generation fuel sources more competitive. However, the lost project pipeline capacity in natural gas combined cycles has not been replaced with equivalent capacity in coal or nuclear projects.

Figure 2: Natural Gas Combined Cycles Cumulative Capacity in the Project Pipeline since 2000
Source: Energy Velocity data as of April each year, CRA Analysis
Click here to enlarge image

Although there has not been a significant amount of new coal-fired base load generation in operation since 2000, there has been a relatively constant amount of capacity in the pipeline until this past year (Figure 3). Recent changes in carbon policy and regulatory recovery have changed this pattern to increase the cumulative capacity cancelled and postponed from approximately 35 percent of the projects proposed since 2000 to 55 percent as of April 2008. Integrated gasification combined cycles, or IGCC, exhibits a similar pattern (Figure 4).

Figure 3: Coal-fired Units Cumulative Capacity in the Project Pipeline since 2000
Source: Energy Velocity data as of April each year, CRA Analysis
Click here to enlarge image

In contrast, nuclear capacity in the project pipeline more than tripled from 2006 to 2008 (Figure 5). This renaissance may result from higher oil prices and uplift from a potential carbon tax. Longer lead times associated with nuclear construction (approximately 10 years versus the two years required for gas units) also offer greater option value due to a longer time frame during which the option to cancel or delay may be exercised. As an example, the decline in capacity in the permitted/feasibility study phase in 2008 compared to the prior year illustrates how projects can be postponed, cancelled or sent back to the pending stage at any time.

Figure 4: Integrated Gasification Combined Cycles Cumulative Capacity in the Project Pipeline since 2000
Source: Energy Velocity data as of April each year, CRA Analysis
Click here to enlarge image

The value of up-front options: Paradise found?
These examples illustrate the flexibility of real options that is not normally associated with the operation of must-run generation. The values of these up-front option values increase with volatility much more than the value of the project itself. As a result, base load generation investors are purchasing and exercising real options as a means of hedging against uncertainty. By proposing new capacity, they purchase a call option on a new plant; deferring investment is equivalent to buying a call option on the project; and cancelling a project is the same as exercising a put option (see sidebar).

Figure 5: Nuclear Facilities Cumulative Capacity in the Project Pipeline since 2000
Source: Enery Velocity data as of April each year, CRA Analysis
Click here to enlarge image

By purchasing or exercising real options, investors in base load generation respond to industry uncertainty and hedge against volatility. The unfortunate result is multiple cancellations or project postponements that exceed the size of new capacity entering the project pipeline. Assuming that new generation projects are needed, how can investors achieve a balance of risks and returns that makes it possible to go ahead with investments? One answer: create alternative hedging structures so that investors 1) purchase more expansion options; and 2) stop exercising their abandon-ment options.

One way to mitigate uncertainty is to protect base load generation profits using hedges that already do exist in the marketplace. For regulated utilities, this hedge takes the form of a guaranteed sale (i.e., a short position to offset the long forward) to ratepayers at a strike price high enough to produce a regulated return. Competitive electricity markets use different structures such as futures, bilaterally-traded forwards and capacity auctions to lock in short positions for certain portions of the spread. Making these hedges more attractive will encourage investors to invest in the upfront cost of proposing a new project (i.e., purchasing an expansion option) and continue to push the project through the pipeline instead of exercising their abandonment options.

To this end, regulated utilities should engage in a comprehensive, fully documented negotiation with stakeholders to establish firm regulatory contracts that allow investment in base load generation to proceed. Regulators should provide guarantees for at least initial activity that place potential projects in the pipeline. In competitive markets, regulators should develop appropriate market structures to hedge base load investment such as competitive retail markets, clear and transparent wholesale markets around which financial positions can be traded, and markets for other generation outputs such as capacity.

Another approach is to value a potential project using real options theory to make sure the project is not being undervalued. In broad terms, a real options analysis would identify the source of uncertainties surrounding an investment decision, understand the drivers of uncertainty, develop scenarios of potential outcomes, determine mitigating actions that could minimize the impact of unfavorable scenarios and increase more favorable results, and assign likelihood to each outcome. These steps alone promise to provide an investor with the critical information and understanding required to create a set of milestones against which progress can be made and serve as the stepping stones to a long-range plan for building base load generation. They also serve as inputs to a more formal decision tree analysis, monte carlo simulation or real options valuation, for those looking for numbers to justify investment decisions.

Final Judgment

In the absence of regulatory certainty, investors can maintain flexibility in base load generation investment by practicing real options theory. A phased decision-making approach allows base load generation investors to maximize their project value with respect to size, technology and timing of operational launch. A real options exercise also provides inputs to a more formal valuation that takes into account the increased value of embedded options. Regulators understanding these steps can take measures to encourage more proposals and pending applications, thereby increasing the number of call options on future projects. Investors in competitive markets can use real options to maximize their value.

When it comes to base load generation, one can do more than simply wait and hope.

Real Options in Base Load Generation Investment

Investors in base load generation obtain flexibility by exercising their real options during the investment process. The following actions are equivalent to purchasing or exercising options:

Proposal/Application = Expansion Option

Making a minimal upfront investment in a proposal creates the opportunity for expanding the output if conditions become favorable. This is the equivalent of a call option on the value of the project with the strike price equal to the investment required to make the project operational. The rise in proposed nuclear and IGCC projects, as well as the constant level of proposed projects for coal, illustrates investors are purchasing an expansion option for certain types of base load generation.

Scaling Back = Contraction Option

During the feasibility/permitting stage, investors have the ability to scale back a project’s capacity with an expansion option under certain conditions. Scaling back the capacity is an exercise of an American put option on the value of the lost capacity. Investors exercise the put option to contract when the present value of future expenditures on the reduced capacity is higher than the value of the lost capacity.

Postponement = Option to Defer

Postponing a project is the equivalent of purchasing an American call option on the value of the project where the strike price is the investment required to realize the project. One can also exercise an option to defer during the construction phase by delaying down purchases and site preparation.

Cancelling a Project = Abandonment Option

Closing down a project or selling the rights to proceed with a project are abandonment options, the equivalent of an American put option on the project’s value where the strike price is the cancellation cost. Investors cancel a project (i.e., exercise their abandonment option) when the liquidation or resale value of the project less any transaction costs is greater than the project value.

Note: Real Option Terminology adopted from John C. Hull, “Options, Futures and Other Derivatives,” 6th edition.


Tanya Bodell is vice president in the energy and environment practice at CRA International Inc., an economic and management consulting firm, an MIT Sloan Fellow and vice chair for the ICC International Centre for Expertise. In trading and risk management, Bodell’s work spans all energy-related commodities, including regulatory compliance, tradebook valuation, and portfolio optimization. Contact her at

The author thanks Patrick Zomer for his assistance in analyzing the data and developing the graphs.


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