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Gas fired power plants: Investment timing, operating flexibility and abandonment

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  • Fleten, Stein-Erik
  • Näsäkkälä, Erkka

Abstract

We analyze investments in gas-fired power plants under stochastic electricity and natural gas prices. A simple but realistic two-factor model is used for price processes, enabling analysis of the value of operating flexibility, the opportunity to abandon the capital equipment, as well as finding thresholds for energy prices for which it is optimal to enter into the investment. Our case study uses representative power plant investment and operations data, and historical forward prices from well-functioning energy markets. We find that when the decision to build is considered, the abandonment option does not have significant value, whereas the operating flexibility and time-to-build option have significant effect on the building threshold. Furthermore, the joint value of the operating flexibility and the abandonment option is much smaller than the sum of their separate values, because both are options to shut down. The effects of emission costs on the value of installing CO2 capture technology are also analyzed.

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File URL: http://mpra.ub.uni-muenchen.de/15716/
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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 217.

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Date of creation: Mar 2003
Date of revision: Jun 2006
Handle: RePEc:pra:mprapa:217

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Keywords: Real options; spark spread; gas-fired power plant; forward prices;

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  1. Denny Ellerman, 1998. "Note on The Seemingly Indefinite Extension of Power Plant Lives, A Panel Contribution," The Energy Journal, International Association for Energy Economics, International Association for Energy Economics, vol. 0(Number 2).
  2. Heath, David & Jarrow, Robert & Morton, Andrew, 1992. "Bond Pricing and the Term Structure of Interest Rates: A New Methodology for Contingent Claims Valuation," Econometrica, Econometric Society, Econometric Society, vol. 60(1), pages 77-105, January.
  3. Chamorro Gómez, José Manuel & Abadie, Luis M., 2005. "Valuing Flexibility: The case of an Integrated Gasification Combined Cycle Power Plant," IKERLANAK, Universidad del País Vasco - Departamento de Fundamentos del Análisis Económico I 2005-21, Universidad del País Vasco - Departamento de Fundamentos del Análisis Económico I.
  4. Schwartz, Eduardo S, 1997. " The Stochastic Behavior of Commodity Prices: Implications for Valuation and Hedging," Journal of Finance, American Finance Association, American Finance Association, vol. 52(3), pages 923-73, July.
  5. Eduardo Schwartz & James E. Smith, 2000. "Short-Term Variations and Long-Term Dynamics in Commodity Prices," Management Science, INFORMS, INFORMS, vol. 46(7), pages 893-911, July.
  6. Nasakkala, Erkka & Fleten, Stein-Erik, 2005. "Flexibility and technology choice in gas fired power plant investments," Review of Financial Economics, Elsevier, Elsevier, vol. 14(3-4), pages 371-393.
  7. Majd, Saman & Pindyck, Robert S., 1987. "Time to build, option value, and investment decisions," Journal of Financial Economics, Elsevier, Elsevier, vol. 18(1), pages 7-27, March.
  8. Siddiqui, Afzal S. & Maribu, Karl, 2009. "Investment and upgrade in distributed generation under uncertainty," Energy Economics, Elsevier, Elsevier, vol. 31(1), pages 25-37, January.
  9. McDonald, Robert & Siegel, Daniel, 1986. "The Value of Waiting to Invest," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 101(4), pages 707-27, November.
  10. Fama, Eugene F & French, Kenneth R, 1987. "Commodity Futures Prices: Some Evidence on Forecast Power, Premiums,and the Theory of Storage," The Journal of Business, University of Chicago Press, University of Chicago Press, vol. 60(1), pages 55-73, January.
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Cited by:
  1. Sven-Olov Daunfeldt & Matilda Orth & Niklas Rudholm, 2010. "Opening Local Retail Food Stores: A Real-Options Approach," Journal of Industry, Competition and Trade, Springer, Springer, vol. 10(3), pages 373-387, September.

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