Spreading Value: How Environmental Policy Changes the Calculation

by Tanya Bodell, CRA International Inc.

“Economists who speak the English tongue are strangely intimidated by mathematical symbols.“
A.L. Nichol, “Journal of Political Economy” 42(2) (April 1934)

Following the U.S. House of Representatives’ passage of the Waxman-Markey bill, the nation might be closer to a comprehensive energy policy on carbon limits, renewable resources and technological investment. Although such policy has been anticipated and incorporated into asset valuations, the tradable property rights of carbon credits under a cap-and-trade program and renewable energy credits (RECs) will generate separate revenue and cost streams for power plants. To properly value profits and create financial hedging mechanisms for power production, a new set of concepts built around the spark spread is useful.

Spark Spread

The spark spread can be expressed in dollars per megawatt hour and is the theoretical difference between the price at which electricity from a natural gas power plant can be sold less the cost of the fuel required to produce that energy. It is theoretical because the general practice of defining the spark spread standardizes the efficiency of the plant to be 55 percent and excludes operations and maintenance and other variable costsassociated with a specific plant. If the plant-specific efficiency and variable costs were included, the spark spread calculation would represent the marginal revenue from operating a specific generation unit–a microeconomic underpinning of the production decision. If the marginal revenue by the spark spread is greater than zero, the plant should dispatch at a profit; if negative, the plant would operate at a loss or not dispatch at all. Therefore, the spark spread represents a hedge to the fuel-for-power swap embedded in any natural gas plant. The proposed Waxman-Markey bill modifies this power production calculus.

Clean Spread

The spark spread of a natural gas generating unit will need to become a clean spread in which the spark spread is reduced by the price of carbon multiplied by a standardized emission intensity factor (in carbon tons per megawatt hour). In other words, a hedge for a natural gas plant will incorporate the cost of carbon into its equation.

Dark Spread

Coal-fired units use an analogous metric, the dark spread, defined as the price of electricity less the cost of coal. Coal plants will hedge using a dark green spread, reducing the dark spread by the cost of emitted carbon per megawatt hour of power produced at a standardized emissions intensity factor. In the U.K. and Germany, the standard dark spread assumes a fuel-efficiency factor of 35 percent. In reality, each coal plant has a different efficiency factor and the type of coal has varying energy content, but the standardized formula can serve as a hedge.

Quark Spread

The quark spread of a nuclear plant, defined as the price of electricity less the theoretical cost of nuclear fuel (uranium) will remain the same in light of the negligible direct carbon emissions associated with nuclear power generation. The expected quark spread is likely to be higher as price-setting fossil fuel plants incorporate the cost of carbon that nuclear units can avoid. A market for financial quark spreads is unlikely to take off, however, as an effective hedge would be to short electricity.

Green Spread

Renewable resources (which have close to zero fuel costs) enjoy a green spread, defined as the price of electricity plus the price for RECs. As with the quark spread, the green spread of renewable resources will increase as carbon costs are incorporated into electricity prices but may decline over time as new entry of renewable resources increase the supply of RECs for a given renewable portfolio standard.

Climate Spread

Some markets may trade a climate spread. Defined as the dark green spread minus the clean spread, the climate spread represents the difference in the cost of production (i.e., the cost of fuel and compliance with carbon policy) between coal- and gas-fired generation. If carbon credit prices rise to sufficient levels, the climate spread could become negative, implying a change in the traditional merit order such that natural gas plants are dispatched before baseload coal.

Environmental policy that puts a price on carbon and creates demand for renewable energy credits changes the calculation of power production profits. Impacts extend beyond fossil fuel plants to all power producers, including renewable resources and nuclear plants.

Author

Tanya Bodell is vice president of CRA International Inc. E-mail her at  Tanya.bodell@fticonsulting.com

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