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Flexibility and technology choice in gas fired power plant investments

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  • Nasakkala, Erkka
  • Fleten, Stein-Erik

Abstract

The value of a gas fired power depends on the spark spread, defined as the difference between the price of electricity and the cost of gas used for the generation of electricity. We model the spark spread using a two-factor model, allowing mean-reversion in short-term variations and uncertainty in the equilibrium price to which prices revert. We analyze two types of gas plants: peak and base load plants. A peak load plant generates electricity when spark spread exceeds emission costs, whereas a base load plant generates electricity at all levels of spark spread. A base load plant can be upgraded to a peak load plant. First, we find the upgrading threshold for a base load plant. The upgrading threshold gives the optimal type of gas plant as a function of spark spread. Second, we calculate building threshold for the investment costs. When the investment costs are below the threshold it is optimal to build the plant. In the numerical example, we illustrate how our model can be used when investments in gas fired power plants are considered.
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Suggested Citation

  • Nasakkala, Erkka & Fleten, Stein-Erik, 2005. "Flexibility and technology choice in gas fired power plant investments," Review of Financial Economics, Elsevier, vol. 14(3-4), pages 371-393.
  • Handle: RePEc:eee:revfin:v:14:y:2005:i:3-4:p:371-393
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    References listed on IDEAS

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    1. Eduardo Schwartz & James E. Smith, 2000. "Short-Term Variations and Long-Term Dynamics in Commodity Prices," Management Science, INFORMS, vol. 46(7), pages 893-911, July.
    2. David G. Laughton & Henry D. Jacoby, 1993. "Reversion, Timing Options, and Long-Term Decision-Making," Financial Management, Financial Management Association, vol. 22(3), Fall.
    3. Schwartz, Eduardo S, 1997. " The Stochastic Behavior of Commodity Prices: Implications for Valuation and Hedging," Journal of Finance, American Finance Association, vol. 52(3), pages 923-973, July.
    4. He, Hua & Pindyck, Robert S., 1992. "Investments in flexible production capacity," Journal of Economic Dynamics and Control, Elsevier, vol. 16(3-4), pages 575-599.
    5. Denny Ellerman, 1998. "Note on The Seemingly Indefinite Extension of Power Plant Lives, A Panel Contribution," The Energy Journal, International Association for Energy Economics, vol. 0(Number 2).
    6. Robert McDonald & Daniel Siegel, 1986. "The Value of Waiting to Invest," The Quarterly Journal of Economics, Oxford University Press, vol. 101(4), pages 707-727.
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    More about this item

    JEL classification:

    • Q40 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Energy - - - General
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies

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