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A Framework Using Two-Factor Price Lattices for Generation Asset Valuation

Author

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  • Chung-Li Tseng

    (Department of Engineering Management and Systems Engineering, University of Missouri--Rolla, Rolla, Missouri 65409)

  • Kyle Y. Lin

    (Operations Research Department, Naval Postgraduate School, Monterey, California 93943)

Abstract

In this paper, we use a real-options framework to value a power plant. The real option to commit or decommit a generating unit may be exercised on an hourly basis to maximize expected profit while subject to intertemporal operational constraints. The option-exercising process is modeled as a multistage stochastic problem. We develop a framework for generating discrete-time price lattices for two correlated Ito processes for electricity and fuel prices. We show that the proposed framework exceeds existing approaches in both lattice feasibility and computational efficiency. We prove that this framework guarantees existence of branching probabilities at all nodes and all stages of the lattice if the correlation between the two Ito processes is no greater than 4/(sqrt)35 (approx) 0.676. With price evolution represented by a lattice, the valuation problem is solved using stochastic dynamic programming. We show how the obtained power plant value converges to the true expected value by refining the price lattice. Sensitivity analysis for the power plant value to changes of price parameters is also presented.

Suggested Citation

  • Chung-Li Tseng & Kyle Y. Lin, 2007. "A Framework Using Two-Factor Price Lattices for Generation Asset Valuation," Operations Research, INFORMS, vol. 55(2), pages 234-251, April.
    • Handle: RePEc:inm:oropre:v:55:y:2007:i:2:p:234-251
    DOI: 10.1287/opre.1060.0355
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    References listed on IDEAS

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    1. Hull, John & White, Alan, 1993. "One-Factor Interest-Rate Models and the Valuation of Interest-Rate Derivative Securities," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 28(2), pages 235-254, June.
    2. Margrabe, William, 1978. "The Value of an Option to Exchange One Asset for Another," Journal of Finance, American Finance Association, vol. 33(1), pages 177-186, March.
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    4. Chung-Li Tseng & Graydon Barz, 2002. "Short-Term Generation Asset Valuation: A Real Options Approach," Operations Research, INFORMS, vol. 50(2), pages 297-310, April.
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    Cited by:

    1. Guoming Lai & Mulan X. Wang & Sunder Kekre & Alan Scheller-Wolf & Nicola Secomandi, 2011. "Valuation of Storage at a Liquefied Natural Gas Terminal," Operations Research, INFORMS, vol. 59(3), pages 602-616, June.
    2. Anna Maria Gambaro & Nicola Secomandi, 2021. "A Discussion of Non‐Gaussian Price Processes for Energy and Commodity Operations," Production and Operations Management, Production and Operations Management Society, vol. 30(1), pages 47-67, January.
    3. J. Muñoz & J. Contreras & J. Caamaño & P. Correia, 2011. "A decision-making tool for project investments based on real options: the case of wind power generation," Annals of Operations Research, Springer, vol. 186(1), pages 465-490, June.
    4. Simshauser, Paul, 2020. "Merchant renewables and the valuation of peaking plant in energy-only markets," Energy Economics, Elsevier, vol. 91(C).
    5. Chung-Li Tseng & Tong Zhao & Chung Fu, 2009. "Contingency estimation using a real options approach," Construction Management and Economics, Taylor & Francis Journals, vol. 27(11), pages 1073-1087.
    6. Tseng, Chung-Li & Zhu, Wei & Dmitriev, Alexandre, 2009. "Variable capacity utilization, ambient temperature shocks and generation asset valuation," Energy Economics, Elsevier, vol. 31(6), pages 888-896, November.
    7. Chung-Li Tseng & Daniel Wei-Chung Miao & San-Lin Chung & Pai-Ta Shih, 2021. "How Much Do Negative Probabilities Matter in Option Pricing?: A Case of a Lattice-Based Approach for Stochastic Volatility Models," JRFM, MDPI, vol. 14(6), pages 1-32, May.
    8. Seiji Harikae & James S. Dyer & Tianyang Wang, 2021. "Valuing Real Options in the Volatile Real World," Production and Operations Management, Production and Operations Management Society, vol. 30(1), pages 171-189, January.
    9. Onur Boyabatlı & Javad Nasiry & Yangfang (Helen) Zhou, 2019. "Crop Planning in Sustainable Agriculture: Dynamic Farmland Allocation in the Presence of Crop Rotation Benefits," Management Science, INFORMS, vol. 67(5), pages 2060-2076, May.
    10. Trigeorgis, Lenos & Tsekrekos, Andrianos E., 2018. "Real Options in Operations Research: A Review," European Journal of Operational Research, Elsevier, vol. 270(1), pages 1-24.
    11. Warren J. Hahn & James S. Dyer, 2011. "A Discrete Time Approach for Modeling Two-Factor Mean-Reverting Stochastic Processes," Decision Analysis, INFORMS, vol. 8(3), pages 220-232, September.
    12. Secomandi, Nicola & Seppi, Duane J., 2014. "Real Options and Merchant Operations of Energy and Other Commodities," Foundations and Trends(R) in Technology, Information and Operations Management, now publishers, vol. 6(3-4), pages 161-331, July.
    13. Nadarajah, Selvaprabu & Secomandi, Nicola, 2023. "A review of the operations literature on real options in energy," European Journal of Operational Research, Elsevier, vol. 309(2), pages 469-487.
    14. Hörnlein, Lena, 2019. "The value of gas-fired power plants in markets with high shares of renewable energy," Energy Economics, Elsevier, vol. 81(C), pages 1078-1098.
    15. Li, Yihua & Tseng, Chung-Li & Hu, Guiping, 2015. "Is now a good time for Iowa to invest in cellulosic biofuels? A real options approach considering construction lead times," International Journal of Production Economics, Elsevier, vol. 167(C), pages 97-107.
    16. Fleten, Stein-Erik & Näsäkkälä, Erkka, 2003. "Gas fired power plants: Investment timing, operating flexibility and abandonment," MPRA Paper 217, University Library of Munich, Germany, revised Jun 2006.
    17. Bastian-Pinto, Carlos & Brando, Luiz & Hahn, Warren J., 2009. "Flexibility as a source of value in the production of alternative fuels: The ethanol case," Energy Economics, Elsevier, vol. 31(3), pages 411-422, May.
    18. Elias, R.S. & Wahab, M.I.M. & Fang, L., 2016. "The spark spread and clean spark spread option based valuation of a power plant with multiple turbines," Energy Economics, Elsevier, vol. 59(C), pages 314-327.
    19. Briest, Gordon & Lauven, Lars-Peter & Kupfer, Stefan & Lukas, Elmar, 2022. "Leaving well-worn paths: Reversal of the investment-uncertainty relationship and flexible biogas plant operation," European Journal of Operational Research, Elsevier, vol. 300(3), pages 1162-1176.
    20. Contreras, Javier & Rodríguez, Yeny E., 2014. "GARCH-based put option valuation to maximize benefit of wind investors," Applied Energy, Elsevier, vol. 136(C), pages 259-268.
    21. Fleten, Stein-Erik & Näsäkkälä, Erkka, 2010. "Gas-fired power plants: Investment timing, operating flexibility and CO2 capture," Energy Economics, Elsevier, vol. 32(4), pages 805-816, July.
    22. Glensk, Barbara & Madlener, Reinhard, 2019. "The value of enhanced flexibility of gas-fired power plants: A real options analysis," Applied Energy, Elsevier, vol. 251(C), pages 1-1.
    23. Sripad K. Devalkar & Ravi Anupindi & Amitabh Sinha, 2011. "Integrated Optimization of Procurement, Processing, and Trade of Commodities," Operations Research, INFORMS, vol. 59(6), pages 1369-1381, December.

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