Valuation of a spark spread: an LM6000 power plant

This paper analyzes a power plant powered by two General Electric LM6000 gas turbines combined with a steam generator that allows combined cycle operations. We consider four distinct operating modes for the plant. Such a plant can be characterized as a real option on a spark spread: optimally converting natural gas to electricity. We use a Margrabe approach by using the market heat rate (the ratio of the electricity price to the natural gas price) as our underlying stochastic variable. We estimate a stochastic model for market heat rates that incorporates time of day, day of week, month, and the incidence or otherwise of a spike in heat rates. We use the model and its residuals in a bootstrap process simulating future market heat rates, and use a least-squares Monte Carlo approach to determine the optimal operating policy. We find that the annual average market heat rate is a good explanatory variable for the time integral of the plant operating margin, denominated in the natural gas numeraire. This allows us to express plant values in terms of the numeraire and convert to dollars by multiplying this by the natural gas forward curve and a forward curve of riskless discount rates. We also provide information about the optimal operating modes selected, the number of transitions between modes and how they relate to transition costs and the average heat rate for the year.