The real option to fuel switch in the presence of expected windfall profits under the EU Emission Trading Scheme

ABSTRACT This paper develops a simple model for evaluating the value and the activation frequencies of a generation system consisting of coal-fired and gas-fired power plants, using a real-options approach and the notions of clean-spark and clean-dark spreads. Under a cap-and-trade scheme, the use of emission permits represents an opportunity cost. In the energy industry, different generation technologies produce different levels of CO2 emissions and, therefore, different opportunity costs. Addressing the question of how real expected windfall profits affect the profitability of a generation plant and its activation frequencies, this paper shows that conventional findings are reversed. When the opportunity cost is internalized, the rate of activation of the gas plant decreases while that of the coal plant increases.