SUMMARY

• Designed to specifically aid valuation and investment decision-making within the energy industry

• Brings together the leading practitioners, consultants and academics from the energy sector who present the most up-to-date real option approaches and techniques, such as the diagrammatical approach, to help the industry move away from the current climate of uncertainty in the market

• Provides brand new case-studies and examples of the use of real options in the industry to demonstrate how the latest techniques can be applied to power generation, fuel supply and demand issues, and strategic as well as environmental issues in the energy sector

• Additionally, includes the fundamentals of real option pricing and modelling, such as option valuation, modelling approaches, and optimisation

• Emphasises applications of theory to practical situations with worked examples that enable the reader to adopt them in their own projects

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 TABLE OF CONTENTS

CONTENTS

Introduction
Ehud Ronn

PART I: OPTIONS FROM OPTIONS: FINANCIAL OPTIONS MEET REAL OPTIONS

1 Risk-Neutral Stochastic Processes for Commodity Derivative Pricing: An Introduction and Survey
Duane J. Seppi

2 Options and Option Valuation Techniques
Steve Leppard

3 Diagrammatic Approach to Real Options
Steve Leppard and Fabio Cannizzo

4 Optimisation and Optimisation Techniques
Shannon Burchett and Deepankar Biswas

5 Applying Stochastic Dynamic Programming to the Valuation of Gas Storage and Generation Assets
Tom Weston

6 Derivative Modelling Approaches in Real Asset Valuation
Sailesh Ramamurtie, Aram Sogomonian, Adrian Dragulescu and Larry Li

PART II: REAL OPTIONS AND THE ENERGY INDUSTRY: APPLYING REAL OPTION VALUATION TO POWER GENERATION AND ANCILLARY SERVICES

7 Operating and Risk Managing Power Plants
Alexander Eydeland and Krzysztof Wolyniec

8 Power Plant Operations and Real Options
Chung-Li Tseng and Graydon Barz

9 Valuing and Hedging Real Options
B. Sailesh Ramamurtie and Brian Bizzano

10 Peaking Plant Valuation: A Discounted Cashflow/Real Option Comparison
J.P. St. Germain and H. Brett Humphreys

11 Price Spikes and Real Options: Transmission Valuation
Michael Rosenberg, Joseph D. Bryngelson, Nikolai Sidorenko and Michael Baron

12 Price Interactions of Baseload Supply Changes and Electricity Demand Shocks
Robert Elliott, Gordon Sick and Michael Stein

13 Modelling Generation Assets
Blake Johnson and María Inés De Miranda

PART III: PRIMARY INPUTS: GAS AND OIL

14 Valuation of the Operational Flexibility of Natural Gas Storage Reservoirs
Spyros Maragos

15 The Growth of Flexible Offshore Oil Fields
Larry Chorn and Shashidhar Rajagopalan

16 Valuing Proven Undeveloped Petroleum Reserves using Real Options
John McCormack, Gordon Sick and Dan Calistrate

17 Valuation of Petroleum Reserves with Quantity and Price Uncertainties: The Case of Woodside Energy
Stuart Connell

PART IV: STRATEGY AND ENVIRONMENTAL ISSUES IN ELECTRIC POWER

18 Real Options for Real Assets - A No Arbitrage Approach
Chris Harris

19 Schemes of Emissions Management, Bottom up Approaches to Internalising the Cost of Sulphur Dioxide Emissions
Shannon Burchett and Deepankar Biswas

PART V: CASE STUDIES

20 Valuing Generation Assets Using Real Option Competitive Price Analysis: A Step-by-Step Valuation Example for a Portfolio of Generation Assets
Frank S. Li and Wang Chiu

21 Analytical Valuation of a Full Requirements Contract as a Real Option by the Method of Eigenclaims
Valery A. Kholodnyi

APPENDIX

Probability and Stochastic Calculus: Review of Probability Concepts
Michael Rosenberg, Joseph D. Bryngelson and Michael Baron

An Efficient and Accurate Computational Technique for Dynamic Programming with Markov Processes
Alexander Eydeland and Daniel Mahoney

Index

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 QUOTES

″Highly recommendable.″
Tobias Federico, Marketplatz Energie

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 REVIEW

Reviewed by Tobias Federico in Marktplatz Energie 1/2004

″Real options? Never heard of them!,″ a friend from the food industry recently said. What appears to be state of the art in the energy industry, is still a closed book for others. But let's be honest: who knew what real options were in the energy sector five years ago? Although it is actually all quite simple. Every production or valorisation unit (asset) is an option by virtue of its manner of operation. If a power plant runs at good prices, it earns good money. If prices are bad, it stands still. Variable costs are saved and the electricity is bought on the market at prices lower than those for which it could have been generated. One only needs to evaluate this relationship to derive a price for the flexibility of a power plant. This can then be optimised - for example for the target value cash-flow - and that's it. But it is not quite as easy as it sounds. Some market and modelling expertise is required. In his book ″Real Options and Energy Management″, however, Ehud I. Ronn shows that the effort is well worthwhile and that this method can be used to improve the quality of decisions in financial planning.

Ronn has compiled 20 contributions by 40 authors. However, not only the number of authors, but their prestige speak volumes for the book. Seppi, Barz and Eydeland are but some of the great brains in modelling and evaluation of energy prices that give this work a good expert background.

The contributions to Ronn's book can at first sight be subdivided into two categories: those by authors with a great penchant for formulae and those by authors who attempt to describe complex mathematical relationships verbally. The latter are far more pleasant to read, especially since their authors have evidently gone to great pains to make the content comprehensible. The formal contributions entice the reader to follow the mathematics, which is not too difficult, but interferes slightly with reading flow.

The collection of articles is subdivided into five main sections and a mathematical annex. The first section presents an introduction to the problem. Along with the foundations of forward and spot price modelling, it presents option price modelling and, above all, the definition of risk neutrality. This knowledge is indispensable to understanding and evaluating real options and, above all, optimising them in respect to a target value. The methods needed for this purpose are also presented in the first section.

In section 2, real option approaches are then applied to power plants. Here, the focus is on the evaluation of fuel prices and the specifics of power plant operation.

Section 3 investigates the characteristics and evaluation methods of the primary energy sources, oil and gas, in greater detail. For the German market, the contributions devoted to evaluation of gas storage facilities and their optimal operation are likely to be of particular interest.

With only two contributions, the fourth section, devoted to the evaluation of power plants in strategic and emission-technology perspective, is somewhat brief. Finally, the fifth section describes some case studies of real option evaluation for energy-related assets. Here, the geographical focus is clearly on the United States.

The systematic structure of the individual contributions and the entire book are positive. Nonetheless, the individual texts do not depend on each other, so that even cursory readers do not get lost. It is only a shame that the book again has a strong focus on America. The problems that apply there, for example modelling of extreme price peaks, are interesting, but not of major importance to our own closely meshed combine system. The book is nonetheless highly recommendable, especially since some new power plants are to be built in the near future. They will not be as easy to amortise as after the last building boom in the early 1990s, when stable market prices prevailed and costs could be passed on. A correct evaluation of flexibilities under market conditions, perhaps based on the ideas presented in this book, could however let some power plant building plans appear attractive again.

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 AUTHOR BIOGRAPHY

Ehud I. Ronn is a Professor of Finance at the University of Texas at Austin and Director of the Center for Energy Finance Education and Research at the McCombs School of Business. Dr. Ronn obtained his B.Sc. and M.Sc. in Economics at the Technion, the Israel Institute of Technology, and his Ph.D. in Finance from Stanford University. He has published articles on investments, interest rate-sensitive instruments and energy derivatives in the academic and practitioner literature, including Journal of Finance, Journal of Business, American Economic Review and Energy & Power Risk Management. Prior to joining the University of Texas at Austin in July 1988, Dr. Ronn was a faculty member of the business schools at the University of California, Berkeley, and the University of Chicago. While on a two-year 1991 - '93 leave of absence from the University of Texas, Dr. Ronn served as Vice President, Trading Research Group at Merrill Lynch & Co., where he was responsible for the valuation and hedging of a wide array of interest rate-sensitive securities, from callable bonds to exotic options. Since 1993, he has served as consultant to government agencies, an insurance company, investment banks, risk advisory rms and an energy-derivative software vendor in the interest-rate and energy-commodity arenas. In the energy-consulting area, Dr. Ronn has addressed the multiple issues of Risk Assessment; Construction of Optimal Hedge Portfolios; VAR and CVAR; Dual-Fuel Options; Valuation of Load-Following Services; Modelling Energy Prices and Pricing Monthly and Daily Options; and the Valuation and Optimal Management of Storage Facility. Dr. Ronn has addressed practitioner as well as academic audiences at energy conferences and training courses.

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 CONTRIBUTORS

Duane J. Seppi; Steve Leppard; Steve Leppard and Fabio Cannizzo; Shannon Burchett and Deepankar Biswas; Tom Weston; Sailesh Ramamurtie, Aram Sogomonian, Adrian Dragulescu and Larry Li; Alexander Eydeland and Krzysztof Wolyniec; Chung-Li Tseng and Graydon Barz; B. Sailesh Ramamurtie and Brian Bizzano; J.P. St. Germain and H. Brett Humphreys; Michael Rosenberg, Joseph D. Bryngelson, Nikolai Sidorenko and Michael Baron; Robert Elliott, Gordon Sick and Michael Stein; Blake Johnson and María Inés De Miranda; Spyros Maragos; Larry Chorn and Shashidhar Rajagopalan; John McCormack, Gordon Sick and Dan Calistrate; Stuart Connell; Chris Harris; Shannon Burchett and Deepankar Biswas; Frank S. Li and Wang Chiu; Valery A. Kholodnyi; Michael Rosenberg, Joseph D. Bryngelson and Michael Baron; Alexander Eydeland and Daniel Mahoney;
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