When it comes to reducing risk and maximizing value, the most successful market participants do much more than just bid load and offer generation into the day ahead (DA) market.
Relying solely on the spot market introduces unacceptable uncertainty and risk to GENCOs since spot optimization can result in a relatively wide distribution of asset returns such as higher earnings risks.
Conversely, portfolio choice or optionality, allows market participants to better manage risks and extract value arising from uncertainty and volatility.
This final post in the blog series, “7 Habits of Highly Effective GENCOs”, discusses four key functions that effective modeling can improve to ultimately enhance overall trading and position management for risk reduction and profit maximization. They are:
- Position Management
- Bilateral Trading
- Co-optimizing Gas & Power
- Monetizing Extrinsic Value & Delta Hedging
I. Position Management: Long or Short?
Highly effective GENCOs begin each morning with two critical questions:
- Am I net long or short?
- What is my true production cost?
Reducing risks and maximizing value via bilateral and financial trading is impossible without accurately knowing your position. Cursory estimates will exacerbate risks and uncertainty that we seek to eliminate.
Sophisticated market participants utilize software to quickly estimate their net position by considering inputs such as:
- Load (bid and forecasted)
- Generation offers
- Self-schedules and virtuals
- Financial bilateral data
RTO market participants begin each morning “on the clock” preparing portfolios in a rush to beat the market submission deadline. There’s no time to waste manually calculating positions when state of the art software will provide the answer in minutes.
With an increasing reliance on natural gas to complement intermittent resources, there’s a significant requirement for accurate market price and fuel supply forecasts each morning. You need to correctly answer an important question:
“Will my generator be awarded in the day ahead market?”
The natural gas fuel supply challenge is only heightened inside of ISO/RTO markets due to the misalignment of gas and power, as well as the time sensitive and financially binding nature of market activities.
Precious time is also required for risk analysts to perform stochastic simulations (assessing the impact of market price volatilities, unit forced outages, load uncertainties, etc.). Here, automating low value data input tasks allow a trading floor to focus on high value analytical studies. Stochastic forecasts predict the probability of various outcomes under different conditions using random variables.
II. Bilateral Trading
Contrary to some perceptions, organized markets do not replace bilateral transactions altogether. Bilateral trading can complement ISO/RTO markets, while the efficiency and transparency of organized markets benefit bilateral transactions.
Buyers and sellers coalesce inside of markets at hubs, some of which offer more liquidity and volatility than others. For events like planned and unplanned unit outages, these bilateral trading points provide an important risk management tool.
For example, if a market participant loses a generator for a week, they may purchase power at a hub for a fixed price. The hub trade offers price certainty and transparency. The hub purchase also offers an alternative to relying on the spot market to cover your short.
Buyers face greater risks than sellers in waiting to transact in today’s spot markets, so sellers can often charge a premium for bilateral contracts.
Further, bilateral trading in markets relies heavily on precise Locational Marginal Pricing (LMP) forecasts, and the effective GENCO will leverage LMP forecasting solutions to evaluate opportunities and predict market awards.
In today’s markets, most bilateral transactions would be considered short-term, or less than two years.
Long-term bilateral contracts are often viewed as a source of stranded costs should spot prices ultimately fall behind contract prices for a prolonged period. However, even these long term PPAs present additional optionality for a GENCO to produce value via short term bilateral trades.
Many GENCOS view long-term bilateral PPAs as a more cost-effective way to integrate green power into their portfolio. Effective bilaterally trading strategies around these assets may lower the integration costs.
Value is extracted by identifying and monetizing the optionality of these long-term agreements.
III. Co-optimizing Gas & Power
Power plant valuation has traditionally focused on the intrinsic value, or the value of dispatching the plant against prices observed in forward markets. There’s an assumption here that you must use fuel to generate power.
You don’t have to.
As we know, many GENCOs today are experiencing large scale coal retirements coupled with an increase in renewable and gas generation:
Less Coal + More Renewables & Gas = Enhanced Portfolio Optionality
The added optionality gained by increasing the amount of renewable and gas resources in a portfolio enhances risk mitigation along with the ability to monetize asset value opportunities.
Let’s take a moment to consider one strategy to utilize optionality for co-optimizing gas and power in short-term markets.
The spark spread is the difference between the price received by a generator for electricity produced and the cost of the natural gas needed to produce that electricity. It is typically calculated using daily spot prices for natural gas and power at various regional trading points.
Depending on spreads and their liquidity conditions at hubs and pipelines, an opportunity may exist to buy power cheaper than your ability to produce and sell the gas at a profit. In other words, a GENCO could evaluate the optimal solution to either:
- Burn fuel & produce power?
- Transact fuel & power separately?
The only efficient way to identify and capitalize on these optimization opportunities is to utilize advanced modeling capabilities such as stochastic forecasting.
IV. Monetizing Extrinsic Value & Delta Hedging
Power plants may also be viewed as “options” and opportunities exist to monetize extrinsic value, which is the value assigned to an option by factors other than the underlying asset’s price. By extension, this is the opposite of intrinsic value.
For example, fuel and operational flexibility afford chances to monetize the extrinsic value of a power plant. Some coal and gas plants incorporate fuel switching. Operational flexibility refers to power plant dynamic behavior such as start/stop regimen, minimum load and ramping.
If you use a robust unit commitment model (one that offers near real-time decision support, long range planning, and post analytics) you can unearth and monetize the extrinsic value of your entire generation fleet. GENCOs may execute this strategy via a rolling intrinsic or delta hedging strategy that monetizes volatility.
Delta hedging is the process of setting or keeping the delta of a portfolio as close to zero as possible. It’s an active process and ongoing activity performed daily by the portfolio manager. Liquidity challenges with long-term bilateral hedging essentially mandate the highly effective GENCO to use financial options to protect from downside price risk.
As forward prices fluctuate, managers can adjust and improve on forward hedge positions to increase generator returns.
As real-time delivery approaches, they can capture additional value using the operational flexibility (e.g., of a combined cycle asset) to respond to spot market volatility.
Extrinsic value is often not as clear to some as intrinsic value and capturing it relies heavily on market liquidity and clear definition of what are “acceptable” transaction costs.
In order to properly value a generator, it is always useful to consider it as an option with both intrinsic and extrinsic value elements.
Throughout our “7 Habits” blog series, we’ve examined methods and systems that can substantively assist GENCOs in minimizing uncertainties inherent in energy markets – where almost nothing stays the same for long, including:
- Policies and priorities
- Industry structure
- Market design and rules
Dynamism and change are everywhere, demanding the highly effective GENCO take a 360° view of portfolio optimization and management by utilizing techniques and tools such as those referenced in this article (Position Management, Bilateral/Financial Trading, Co-optimizing Fuel/Power, and Monetizing Extrinsic Value).
A GENCO has four primary objectives:
- Automation and streamlining of operations
- Seizing every potential market opportunity
- Cost minimization
- Profit maximization
These objectives must be achieved but further, truly innovative GENCOs must also ensure that commercial operations staff are able to focus on the highest value-added activities. Implementing a platform like PCI GenManager to manage key components of the bid-to-settlement trading cycle empowers employees to devote more time analyzing ways to mitigate adverse portfolio impacts and risks.
PCI’s GenTrader platform allows you to model your entire asset portfolio, including:
- Thermal generation including, complex combined-cycle assets
- Hydro generation (e.g., cascaded and pumped storage assets)
- Renewable generation
- Market prices (power, fuel, ancillary services, emissions, etc.)
- Complex option and forward contracts
- Fuel constraints and energy-limited options
There are other, key capabilities critical to GENCO success today that include:
- Energy Trading & Risk Management (ETRM)
- Post analytics
- Front-to-back office workflow management
- Business Intelligence (BI) and reporting
All of the mission critical functions mentioned should ideally be performed on a single platform in order to create operational efficiency and actionable insights. PCI provides that common platform to enable all of this (and more) across all parts of the highly effective GENCO.