Gas Fire Power Plant Management Through Numerical Approximation of Spark Spread Options

TL;DR

This paper develops numerical methods to approximate spark spread options for gas-fired power plants, accounting for jump diffusion processes in spot prices, enhancing valuation accuracy beyond traditional closed-form solutions.

Contribution

It introduces novel approximation techniques for spark spread options under jump diffusion models, extending valuation methods to more realistic price dynamics.

Findings

Approximation methods effectively handle jump diffusion in spot prices.

Enhanced valuation accuracy for gas-fired power plants with complex price behaviors.

Potential for improved risk management and decision-making in energy markets.

Abstract

Cross-commodity valuation approaches to value gas fire power plants are well studied in the literature. Hence, the value of the gas fire power plant is identical to the value of a spark spread option wherein the underlying are electricity and gas with a strike price assimilated to operating and maintenance costs. Power and fuels spot prices account for uncertain futures cash-flows for power-plant generator owners. For instance, for gas-fired turbine plant, spot prices of electricity and gas determine the random cash-flows of the power-plant. Other than the spot prices, the valuation of such plant involves among other deterministic cost the plant heat rate and operating costs. Recently, the cost of emissions is considered into the valuation to tackle environmental issues. Given some simplifications in the plant cash-flow modelling, the value of such plant can either be expressed as the price of i) a cross-commodity option or ii) the price of a real option. Here, we focus on cross-commodity option valuation approach where the value of the power plant is approached as the value of a spark spread option. When spot prices of the underlying commodities are log-normal, closed formulae or approximations can be obtained using Kirk's approximation. Naturally, the spot price of electricity and gas present spikes due to seasonality among other factors. However, in that case it is not possible to get a closed formula for the spark spread option. In this paper we explore possibilities to approximate spark spread options when spot prices fall into a class of jump diffusion processes.