Friday, 1 March 2013

Winds of Fortune or Despair?

Have you ever been to your local grocery store and get paid at the checkout instead of paying for the contents of your shopping cart? In the European electricity markets this was the case a couple of times in the past few years. Electricity prices turned negative due to excess supply of electricity and low demand. In Europe, electricity comes from various sources. A mix of coal, gas nuclear, hydro and a rising number of wind and solar power plants provide the electricity. Current technology doesn’t allow storing electricity efficiently yet, so demand and supply must be matched at all times, with price as the principle mechanism to steer supply. On the electricity market, the lowest bidder looking to supply the grid with electricity wins. Since wind and sun come at no cost, subsidies for wind or solar power production allow for bids below €0 per unit while the electric company is still making a profit.  Also because nuclear, hydro and coal fired power plants can’t be shut down without considerable cost, electric companies sometimes bid below €0 per unit, simply because the cost of shutting down and restarting is higher.

The uncertainty in electricity (spot) price is only one of the many uncertainties decision makers in the electricity market face in their decision making. The emergence of new technology increases the complexity of their decision making even more. The recent shale gas boom in the US caused electricity generators in the US to switch from coal to gas. As a consequence US coal became cheap and found its way to Europe where it displaced gas. For the future, management of electric companies in Europe are therefore faced with difficult trade-offs. The rising capacity of wind and solar power, forces them towards a flexible mix of gas and wind/solar power. The shale gas boom in the US pushes them towards the use of less flexible coal fired plants. Which portfolio is best and what should be the weights in the portfolio for each of the power sources?
Given the rising complexity of decision making and the number of uncertainties involved, electric companies will benefit strongly from adopting an optimisation based approach. In capacity investments the electric company needs to decide on number, size, and location of new power plants. Also the power source, technology and timing of the investment need to established, all under a variety of economic and technological uncertainties. It’s a complex decision, which management typically solves by simplification. Investment opportunities are intuitively evaluated on a standalone basis, considering only a couple of the most obvious uncertainties. For each investment opportunity a net present value is calculated, which is used to rank the investment opportunities. The top ones in the list are selected as the best possible opportunities and makeup the investment portfolio.

An optimisation based approach to power generation capacity investment decisions however, will allow the electric company to evaluate opportunities in a holistic and coherent manner. Instead of evaluating the investment opportunities on a case by case basis, optimisation based methods allow for connecting the forecasted cash flow of a new power plant with the forecasted cash flow of the rest of the portfolio of power plants. Using Monte Carlo, simulating the performance of the complete portfolio for future values of relevant uncertainties becomes relatively easy. Without this link it is impossible to analyse the future financial and technical performance of the electric company in a consistent manner. An optimisation based approach also allows for decision making based on facts and not biases, predispositions or beliefs because it requires an explicit definition of performance indicators for ranking and choosing between investment portfolios. By carefully analysing the portfolios that are most promising (the ones on the efficient frontier) management can find out which new power plants to invest in. If a certain investment project is part of the majority of the efficient portfolios it certainly would be a good and robust choice to invest in.

Since we can’t predict the future, certainly not for a long period ahead, the electric company must be careful not to fixate its investment strategy for the long term.  Instead, optimisation based analysis allows for periodic reruns of the portfolio model and adaption of the investment strategy as conditions change over time (like increased wind power capacity, new emission regulations, shale gas boom, etc). That way the investment decision is no longer static but becomes dynamic and allows the electric companies to benefit from the winds of fortune, instead of being taken by surprise.