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A Framework Using Two-Factor Price Lattices for Generation Asset Valuation

Department of Engineering Management and Systems Engineering, University of Missouri–Rolla, Rolla, Missouri 65409
Operations Research Department, Naval Postgraduate School, Monterey, California 93943
chungli{at}umr.edu
kylin{at}nps.edu

In this paper, we use a real-options framework to value a power plant. The real option to commit or decommit a generating unit may be exercised on an hourly basis to maximize expected profit while subject to intertemporal operational constraints. The option-exercising process is modeled as a multistage stochastic problem. We develop a framework for generating discrete-time price lattices for two correlated Ito processes for electricity and fuel prices. We show that the proposed framework exceeds existing approaches in both lattice feasibility and computational efficiency. We prove that this framework guarantees existence of branching probabilities at all nodes and all stages of the lattice if the correlation between the two Ito processes is no greater than 4/35 0.676. With price evolution represented by a lattice, the valuation problem is solved using stochastic dynamic programming. We show how the obtained power plant value converges to the true expected value by refining the price lattice. Sensitivity analysis for the power plant value to changes of price parameters is also presented.

Subject classifications: natural resources; energy; finance; asset pricing; real options.
History: Received January 2002; revision received December 2005; accepted March 2002.