This is the third in a series of articles on the principles of energy risk management, written by Nick Perry.
Energy portfolios are rich with physical optionality. For example, options to take different volumes of delivery (e.g. supply contracts), options to convert one type of energy into another (e.g. gas into power) and options to store energy for later use (e.g. gas or hydro storage). The market exposures and values of these options are typically complex. But they are an inherent part of most energy portfolios.
Earlier in this series we have several times mentioned options in the context of energy risk. In particular, we suggested that many aspects of risk management in energy are quite challenging enough even before confronting the additional complexities posed by options. But given their prevalence in most energy portfolios, the treatment of options is an important risk management issue.
The inevitability of options
As discussed last time, uncertainties abound in energy markets. Price risk (exposure to variable prices), volumetric risk (exposure to uncertainty of the amounts of supply or demand to be managed) and basis risk (vulnerability to breakdown in correlations) are all abnormally pronounced, especially in gas and power.
At the same time, reliable physical performance of delivery obligations is commercially and societally critical: we do not tolerate the lights going out. Energy portfolios must accordingly be designed to be resilient, and in general terms this means building in a great deal of flexibility, in order to be able to respond to a range of contingencies.
Under traditional monopoly models, when ‘risk management’ was not really a term of art, flexibility was conceived of largely in terms of substantial over-capacity in physical systems. If one power plant trips, we have others in reserve at our command. But when open markets become the norm, and companies no longer have the luxury of a captive customer base on which to foist the cost of large-scale redundancy, they must expand their understanding of flexibility to embrace commercial and financial tools. In the language of traded markets, they need to incorporate options in the portfolio.
Of course, various forms of contractual optionality have long existed in energy portfolios alongside physical over-capacity: for example, ‘swing’ contracts for gas purchases and interruptible sales contracts all featured in monopoly suppliers’ repertoires. Over time they learn to identify these as optionality, albeit as options ‘embedded’ in ‘physically settled’ contracts. They further observe that in their supply portfolios they have sold a great deal of flexibility to end-users, which again translates into optionality – this time, a short option position, which is generally considered a higher risk exposure. And they see a need to analyse these various “real options” as one would a purely ‘paper’ option contract.
Physical flexibility as an option
But this new way of describing and analysing old tools does not stop at contracts. Through this lens, a flexible gas-fired power plant looks like a way of capturing a positive price-differential between gas and power at the relevant heat-rate (the spark spread), while retaining the ability to turn the plant down when the spark spread is negative.
Thus, capacity in a CCGT can be seen as a strip of call-options on the spark spread, yielding positive pay-offs when they are available, and (ideally) never incurring a negative marginal outcome. The pay-off diagram (shown in Chart 1 below) has an additional dimension to that of the classic call-option on an equity: but it is clearly an option nonetheless.
The same reasoning can be applied to a very significant set of classic steel-and-concrete energy assets. Oil refineries, transmission systems and storage facilities are all good examples. ‘Call-options on spreads’ may not be how they were conceived of by the engineers who built them; but that is how risk managers and portfolio managers need to analyse them.
Complexities galore
One great advantage of this way of looking at energy portfolios is that the financial theorists have equipped us with ways of valuing options as assets, assessing the risks of holding them unhedged in the portfolio, and devising hedging strategies to protect their value.
That’s the good news. The bad news is that many of these ‘real options’ are particularly difficult to model.
This is intrinsically bound up with the challenge of exercising these particular options optimally. Option theory tends to start from a simple call option on an equity that can be exercised once only, at a particular point in time, in a market of complete transparency and liquidity. Optimal exercise of the option is so straightforward, your broker will do it for you.
But consider the case of a coal-fired power plant that is ‘opted out’ under the European Large Combustion Plants Directive. The owner would like to operate it as a call-option on the ‘clean dark spread’ and generate when and only when there is a positive spread. This implies on-off actions at the start and end of periods in the day when a positive prevails. But the output of a coal plant is constrained to ramp up and down relatively slowly, so that some periods of sub-optimal ‘exercise’ of the option are inevitable.
Complicating matters still further, the opted-out plant has only a finite number of running hours permitted. The dark spread may be high right now: but perhaps it will be even higher in the months to come, and we may regret using finite running hours now rather than generating more profitably later. Then again, running the plant more aggressively now may advance and/or lengthen the timing of a maintenance outage, when we would lose potentially more profitable generating opportunities.
Addressing the challenge
These problems are multi-dimensional and make our valuations, risk assessments and hedging strategies very challenging indeed. Financial theory may give us a head-start, providing a framework for the analyses we would like to conduct, and a template for the strategies we would like to deploy. But at the trickier end of the spectrum we will rapidly encounter severe difficulties, from the complexity of modelling the option to the illiquidity of the market in which hedges must sourced.
Yet the portfolio manager and the risk manager cannot avoid them. The time-honoured principle – “if we can’t analyse it, we won’t do it” – might deter, say, a hedge fund from buying a power plant. But is not of much help to a utility whose core business is owning and operating these assets, which represent substantial amounts of their capital at risk. If the optionality in the take-or-pay structure of a long term gas supply agreement defies analysis, that is a good reason for not signing the contract. But if it is already a substantial component of the legacy portfolio, avoidance is no longer an alternative.
As in so many real-life situations, the solution will lie in a blend of strong theory and robust pragmatism. Without the theory, we don’t even know the direction we’d ideally like to take, and cannot begin to optimise our position. Without the ability to make intelligent compromises in the face of reality, we may find ourselves frustrated to the point of inertia.
Where water-tight text-book risk management solutions are not available, we will still be better placed by bringing to bear the best analyses possible, in combination with experience and judgment. An 80% solution is a big improvement on none. And this is nowhere more applicable than in risk-managing real options in energy portfolios.
Nick Perry is a Senior Advisor with Timera Energy. He has extensive energy industry expertise specialising in portfolio & transaction structuring, risk management, market dynamics and regulatory issues. He has spent over 20 years working in the gas and power industries for Exxon, Amoco and Enron, where he was a Board Director of Enron Europe.
Timera Energy provides tailored in-house corporate training services covering, amongst other areas, energy risk and portfolio management. If you are interested in finding out more please contact us.
