by Tanya Bodell, FTI Consulting
Coal plants are experiencing a new economic reality. Traditionally baseload, some mid-merit coal units now have economics more similar to peaking units with variable costs of production above off-peak market prices. These coal units are modifying daily operations and contemplating wet layup for shoulder months. Valuation of these assets needs to reflect the real options these plants now represent.
Intrinsic and Extrinsic Value
The value of an option is composed of intrinsic and extrinsic value. The intrinsic value is 1) the difference between the value of the underlying asset and the strike price if positive (i.e., “in the money”), or 2) zero if the strike price is above the price of the underlying asset (i.e., “out of the money”). Option prices trade above the intrinsic value of the underlying asset. For example, an option that is slightly out of the money with zero intrinsic value still trades at a positive price to reflect the probability that the option will be back in the money before expiration. Extrinsic value, the price of the option less the intrinsic value, increases with volatility and length of time before expiration.
Valuing Generation Plants as an Option
The electricity industry established the concept of valuing natural gas peaker plants using options pricing more than a decade ago. Such valuations work off the spark-spread principle that a natural gas power plant has the operational flexibility and the right but not the obligation to sell electricity into the wholesale power market. The strike price is the variable cost of producing a megawatt-hour of electricity. If the price of the underlying asset (i.e., wholesale electricity) is above the strike price, the spark spread is positive and the plant produces power. If the spark spread is negative, the plant shuts down, resells its fuel into spot gas markets, and margins are zero. Given their comparable payout structures, the intrinsic value of the spark spread of a natural gas generating facility is similar to that of a call option.
If a generating unit is deep in the money, such as an inframarginal base-load plant, the asset has little economic option value. Valuation of such baseload units discount expected cash flows, with scenario analysis to understand risks. Using the same approach for a peaking unit, however, undervalues the extrinsic value of the option and therefore the total value of the plant.
The New Economics of Coal Plants
In some markets, mid-merit coal plants are now at the money, meaning the marginal profit is at or close to zero. During on-peak hours, these coal plants can be profitable and can operate. Off-peak prices, however, no longer cover the variable costs of producing electricity. The strike price has increased as fuel costs, transportation costs and ash removal expenses have increased; the price of underlying electricity prices has decreased because of lower gas prices, depressed demand and increases in inframarginal units such as renewable resources. Dark spreads, the difference between the electricity price and the marginal cost of coal, are thinner.
Responding to these thinning spreads is a challenge. In contrast to natural gas plants, coal plants have less operational flexibility to cycle on and off but can ramp down to minimum generation levels. Operational flexibility improves over a longer time as coal plants can be placed into wet layup, ready to restart within a week in response to changes in market conditions, or simply shut down if long-term economics determine. Unused fuel often can be resold into global coal markets. Such flexibility creates option value.
Implications for Valuation
The extrinsic value of an option is greatest when the option is at the money. Extrinsic value also increases with uncertainty—volatility—in the underlying asset. Between the current economic situation and significant uncertainty associated with future environmental costs, fuel costs and therefore electricity prices, some mid-merit coal plants might appear to have little intrinsic value using a discounted cash flow analysis. Valuing such a coal plant without considering the extrinsic value of the real option that such a plant represents could understate the value. Real options valuation is employed by sophisticated investors.
Failure to consider the extrinsic value can cause buyers to underbid and sellers to underask. Whether buying, selling or holding, pay attention to the potential for real option value in your power generating assets.
Tanya Bodell is a managing director at FTI Consulting and co-founder of the Electricity Consulting Group. Reach her at firstname.lastname@example.org.
“Business is beginning to recognize the value of real options analysis as demonstrated by at least three recent articles on this topic in the Harvard Business Review.”
James Alleman, 2000
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