Real Options & The Philippine Power Markets
We’re turning a corner in the Philippine power markets. The strategic decision making on how much future price volatility risk the cooperatives’ consumers are exposed to has been taken out of the hands of Napocor managers and placed into the hands of the EC managers.
But something very important has happened in the energy industry over the past several years along with the development competitive energy markets. The analytical tools and the way of thinking about how we make strategic decisions on electric power supply has drastically changed – and this is now available to EC Managers in a way that was never available to Napocor managers. Just as cell phone technology allowed provincial customers to leap-frog the old technology of building out landlines, the use of concepts and tools related to the use of financial derivatives, borrowed from the financial industry but now pervasive throughout the energy industry, will allow EC Managers to fully assess the strategic value of power supply options – enabling them to address market uncertainty in ways that are far superior to how Napocor manager’s approached the problem of uncertainty.
For each and every year post-2010, the ECs will be completely exposed to unregulated market prices. That can be a good thing. Those prices might be very low – or they might be very high. Frankly, no one knows. So there is a lot of uncertainty. The time to hedge that uncertainty – i.e. to position the EC to limit its exposure to the downsides of uncertainty while maximizing its ability to take advantage of the upsides of uncertainty – is now. It takes a one to two year lead time, or more, to get those hedges in place.
We won’t be using derivatives in the Philippine energy markets for some years to come (but it may be sooner than you think). But a new way of thinking about and analyzing strategic options (i.e. real options, like a power plant) will take hold immediately and it will transform the EC Manager’s ability to position the EC for dealing with uncertainty.
Let’s take an illustrative example and look at the potential of a new power plant for an EC that will lose it’s TSC in 2011. If the EC takes no action, it will start paying whatever market prices exist at the time – in 2011 and beyond.
The power plant, if we have dispatchable rights to it, can be viewed as an option – similar to a financial option on Wall Street. We will pay some fixed amount to secure the option to dispatch the plant in any particular hour. The fixed costs embedded in the Power Sales Agreement is basically the “cost of the option”. The variable cost embedded in the Power Sales Agreement is basically the “strike price”.
We will exercise the option whenever the hourly spot price exceeds our strike price. During such hour that we dispatch the plant, we make a margin – the difference in the spot price and the strike price. During peak hours we might make a large margin. During shoulder hours we might make a very small margin. During off peak hours we will probably not dispatch the plant at all and therefore make zero margin. The dispatchability allows us to take advantage of all the upside uncertainty on hourly prices – and we have no downside loss since we simply shut the plant and incur no fuel cost. We do however always have to pay the fixed costs – that is simply the “cost” of securing the option in the first place. So the question becomes: do we expect that the hourly margins we make on the upside offset the fixed costs we incur.
We have tools and techniques to assess this. And these tools and techniques allow us to structure the option such that the upside opportunities will be expected to not only occur more frequently but also occur in much bigger sizes than the downside (i.e. not covering the fixed costs) risks. This type of analytical framework has, until fairly recently, never been available to the Napocor managers – even if they cared about it.
The real options approach changes utility business decisions. It provides a way to measure the value (or loss in value) of waiting-to-invest, for example. It provides a way to measure the benefits of follow-on expansion options if an initial option works out well and dial that into our considerations. It allows us to measure the value of flexibility (such as the above example). It allows us a way to evaluate how long we should wait before walking away from an investment that is not currently working out. It allows us a way to evaluate how staged investments can increase value of later decisions by increasing information that we don’t have up front.
This new framework for thinking about uncertainty doesn’t guarantee that events will turn out advantageous. It will increase the chances of that and importantly it will allow us to increase the payoff if there is a good outcome.
This is why today’s and tomorrow’s EC Managers will kick butt. They have an opportunity to become real heroes in managing strategic decisions on behalf of the electricity consuming public.