Valuation of Energy Assets: Three Risk Factors

Abstract

This chapter goes another step forward by considering three sources of risk in the valuation process. We assess a couple of opportunities to invest in energy assets when environmental constraints are in place. First we deal with a combined cycle gas turbine. Both the electricity price and natural gas price are governed by mean reverting stochastic processes as in the two previous chapters; however, the carbon allowance price is assumed to follow a geometric Brownian motion. Again we go through the computation of the net present value of an immediate investment in this plant; hence we derive the value of the option to invest in it over the next ten years. We check for the sensitivity of our results to changes in the capacity factor, and the long-term electricity price. We also compute the NPV and the option value under different cross correlations, on one hand, and different combinations of the three volatilities, on the other. The second case concerns a coal-fired station when coal, electricity, and carbon prices evolve stochastically over time. As usual, numerical estimates of the underlying parameters in the three commodity price processes have been computed from futures prices. Besides, the optimal boundary (now a plane) between the investment region and the continuation region in the three-dimensional input fuel/output prices space is derived.