1 Systems Analysis Advisory Committee (SAAC) Tuesday, April 29, 2003 Michael Schilmoeller John Fazio

Northwest Power Planning Council 2 Agenda Approval of the March 31 meeting minutes Decomposition of risk associated with a firm contract Planning flexibility valuation Scenarios in a stochastic framework

Northwest Power Planning Council 3 Agenda Approval of the March 31 meeting minutes Decomposition of risk associated with a firm contract Planning flexibility valuation Scenarios in a stochastic framework

Northwest Power Planning Council 4 Agenda Approval of the March 31 meeting minutes Decomposition of risk associated with a firm contract Planning flexibility valuation Scenarios in a stochastic framework

Northwest Power Planning Council 5 Objectives Illustrate how risk attributes depend on the portfolio in which they are placed Show how decomposition of these attributes is nevertheless possible

Northwest Power Planning Council 6 Our Example One hour One thousand MW of load Met with a mix of –Wholesale market power Variable market price, lognormal distribution (mean = $37/MWh, standard deviation = 100%) –Variable amount of firm energy contract $15/MW-h ($132/kW-yr)

Northwest Power Planning Council 7 Our Example

Northwest Power Planning Council 8 Our Example Our risk measure: $6000 That is, the dollar threshold such that losses exceed that threshold have an expected value of $6000

Northwest Power Planning Council 9 Changing Margin 400 surplus 300 deficit200 deficit 100 deficit 100 surplus200 surplus 300 surplus 400 surplus

Northwest Power Planning Council 10 Observation This is the situation that many load- serving entities found themselves in after the energy crisis This is the situation that many load- serving entities found themselves in after pursuing individual reserve margin goals in

Northwest Power Planning Council 11 Conclusion Any specific resource can either increase or decrease risk The risk mitigation value of a resource to a portfolio depends on the portfolio

Northwest Power Planning Council 12 Question These leaves us with a potentially difficult analysis Is there anyway to disaggregate the risk attributes of this contract?

Northwest Power Planning Council 13 Answer Value each component of the portfolio in the market and superimpose

Northwest Power Planning Council 14 Example Warning: positive numbers are now benefit, not cost.

Northwest Power Planning Council 15 We started out with

Northwest Power Planning Council 16...obtained the net position...

Northwest Power Planning Council 17...applied a probability distri- bution to the net position...

Northwest Power Planning Council and got the result.

Northwest Power Planning Council 19 Decomposition The last step here is realizing that we can superimpose the individual distributions For example, for the 200 MW net deficit position, we had...

Northwest Power Planning Council 20 Total Position

Northwest Power Planning Council 21 Total Position

Northwest Power Planning Council 22 Decomposition But we can recover the same distribution as before, because,

Northwest Power Planning Council 23 Conclusion We can value the two elements of the portfolio, load and contract, against the market and then add them We can value each element of a portfolio against the market, independent of one another, and have the risk mitigation we need to assess the portfolio.

Northwest Power Planning Council 24 Agenda Approval of the March 31 meeting minutes Decomposition of risk associated with a firm contract Planning flexibility valuation Scenarios in a stochastic framework (Done)

Northwest Power Planning Council 25 Objectives Illustrate how valuation of planning flexibility can be performed

Northwest Power Planning Council 26 Overview Review of the Excel function for capturing planning flexibility Describe some experiments performed with one of Olivia’s spreadsheets Summarize an insight Abstract to a quantification principle

Northwest Power Planning Council 27 NPPC Analysis Representations

Northwest Power Planning Council 28 Captured with a User-Defined Excel function

Northwest Power Planning Council 29 Experiment Set up the worksheet for a plant with a construction phase of three periods and no optioning period; and a plant with the same construction phase, but an option period comprising 2 periods. Use the difference in the net revenues over the study period for these plants

Northwest Power Planning Council 30 Experiment Perform simulations, arranging for every possible pattern of criteria appear over the study. For example, if 1 denotes a positive criterion and 0 a negative criterion, and we consider five periods enumerate all the binary numbers between and

Northwest Power Planning Council 31 Results The pattern that gives rise the greatest value of planning flexibility is What is going on here?

Northwest Power Planning Council 32 Prices

Northwest Power Planning Council 33 Construction without Flexibility

Northwest Power Planning Council 34 Construction with Flexibility

Northwest Power Planning Council 35 Construction with Flexibility Valuation is straight- forward, using a geometric series

Northwest Power Planning Council 36 Construction with Flexibility Valuation is

Northwest Power Planning Council 37 Shorter Lead Time

Northwest Power Planning Council 38 Shorter Lead Time Another geometric series

Northwest Power Planning Council 39 Principles of Valuing Modularity As in the first presentation, the value of modularity can be assessed for each resource independent of others Valuation depends on an assumed market price behavior

Northwest Power Planning Council 40 Perfect Foresight The perfect foresight assumption is what we typically use in planning It assumes that plants can be brought on line at the point in time that optimizes their value

Northwest Power Planning Council 41 Value of Capacity with Perfect Foresight

Northwest Power Planning Council 42 Construction with Flexibility

Northwest Power Planning Council 43 Perfect Foresight With perfect foresight, assumed by many of our models, the value of capacity is overstated. It needs to be discounted for decision making under uncertainty. Resources with planning flexibility would see a smaller discount than those without this flexibility.

Northwest Power Planning Council 44 Conclusions Value of modularity can be estimated from a particular pattern of price behavior, using time-value of money calculations and geometric series Resource optionality can be assessed independent of loads and other resources, by assessing in the market

Northwest Power Planning Council 45 Conclusions Plants with planning flexibility should have a smaller value discount relative to plants without such flexibility We expect to be able to verify these values with Olivia Olivia may provide additional insights and working hypotheses for estimating this long-term real option value

Northwest Power Planning Council 46 Agenda Approval of the March 31 meeting minutes Decomposition of risk associated with a firm contract Planning flexibility valuation Scenarios in a stochastic framework (Done)

Northwest Power Planning Council 47 Objectives Explore the value of using subjective probabilities to address future scenarios

Northwest Power Planning Council 48 Types of uncertainty Variability –Predictable –The descriptive statistics, such as mean, dominate the valuation calculation (e.g., hydrogeneration). –Weak temporal correlation (little year to year) Futures –Unpredictable –Only one future will manifest –Stronger temporal correlation

Northwest Power Planning Council 49 Refinements PacifiCorp further distinguishes futures into –“scenario risk,” the consequences of which PacifiCorp feels more comfortable quantifying, although “probabilities can not be assigned,” and –“paradigm risk,” which PacifiCorp feels uncomfortable characterizing quantitatively. These are changes in the underlying structure of the business model

Northwest Power Planning Council 50 Objective of Futures Analysis Illuminate and evaluate the future consequence of today’s decisions Identify “robust” solutions Identify contingency options

Northwest Power Planning Council 51 Example We will Examine three plans in three futures for risk and cost Look at the outcome in terms of risk/cost trade-off and make a decision Look at the outcomes using stochastic analysis and make a decision Compare the outcomes

Northwest Power Planning Council 52 Example CO 2 tax cost mitigation We consider a single year, 2005 We buy a quantity of outsets that matches our production of CO 2

Northwest Power Planning Council 53 Assumptions Tax offsets have price that closely approximates the emission tax rate. Experts expect a $6/ton CO 2 tax around 2005

Northwest Power Planning Council 54 Plans Approaches –Plan to start buying tax offsets at $6/ton in 2005 –Buy tax offsets forward (2005) at $6/ton –Buy options (strike of $10/ton) on tax offsets in 2005 for $1/ton premium.

Northwest Power Planning Council 55 Example Future 1: Insignificant tax Future 2: $15/ton tax in 2005 Future 3: $3/ton tax in 2005

Northwest Power Planning Council 56 Outcomes Future 1: Insignificant tax Wait and buy: we never see anything that concerns us, so we pay nothing Buy forwards: Costs $6/ton Buy options: Costs $1/ton

Northwest Power Planning Council 57 Outcomes Future 2: $15/ton tax in 2005 Wait and buy: Costs $15/ton Buy forwards: Costs $6/ton Buy options: Costs $11/ton ($1/ton premium plus purchase at $10/ton)

Northwest Power Planning Council 58 Outcomes Future 3: $3/ton tax in 2005 Wait and buy: Costs $3/ton Buy forwards: Costs $6/ton Buy options: Costs $4/ton

Northwest Power Planning Council 59 Outcomes

Northwest Power Planning Council 60 Outcomes If we average the costs and use the worst case outcome as a measure of risk, we have the following …

Northwest Power Planning Council 61 Outcomes

Northwest Power Planning Council 62 Results Buying forward “dominates” waiting Buying forwards and buying options are on the “efficient frontier” The forward contract, with no cost uncertainty, is attractive

Northwest Power Planning Council 63 Issues We get new information –A political outcome makes it very unlikely that there will be any CO 2 tax in 2005 This has no impact on the preceding two diagrams, but it has significant impact on our valuation (or, more important, the valuation of the person writing the check)

Northwest Power Planning Council 64 What is going on? The selection of futures we examine has an impact on the construction of the diagrams. Our eye tells us that the points all have equal likelihood, whereas this generally will not be the view of the decision maker.

Northwest Power Planning Council 65 What is going on? If we weight the values by their likelihood, we get an outcome that makes more sense to the decision maker For example, is we believe there is 2/3 probability there will be no tax...

Northwest Power Planning Council 66 What is going on?

Northwest Power Planning Council 67 What is going on?

Northwest Power Planning Council 68 Results Now the wait strategy is practically dominated by the buy option strategy, but there is a much more clear trade-off between the option strategy and the forward strategy If it is truly unlikely there will be a CO 2 tax in 2005, forward contracts look like a waste of money.

Northwest Power Planning Council 69 Results If we use something like CVar for our risk measurement and have more points, the risk could also change ranks among the plans

Northwest Power Planning Council 70 Conclusions When we use frequency-based probabilities in “stochastic” analysis, we typically concerned with the descriptive statistics for the distribution, such as mean.

Northwest Power Planning Council 71 Conclusions When we use subjective probabilities for analysis of futures, we are using them to identify plans that are “robust,” i.e., plans that perform well in most of the likely futures and do not perform terribly poorly in the worst cases.

Northwest Power Planning Council 72 Conclusions Subjective probabilities permit us to more realistic attribute value to contingency options As a practical matter, we experts and analysts will advise the decision makers regarding the likelihood of various futures, although the ultimate assessment always must reside with them.

Northwest Power Planning Council 73 Agenda Approval of the March 31 meeting minutes Decomposition of risk associated with a firm contract Planning flexibility valuation Scenarios in a stochastic framework (Done)

Northwest Power Planning Council 74 Next Meeting Next meeting June 5, 2003 –More discussion of statistics –Results with Olivia

Northwest Power Planning Council 75 Risk Mitigation Options. Right, but not the obligation to take a particular action or engage in a particular transaction. Has two sides, and must be traded between participants. Usually asymmetric with respect to a given risk: limits outcome in a single direction. Hedging. Commitment to action or transaction that reduces the variability or uncertainty of outcome. Does not provide optionality. Usually symmetric with respect to a given risk: limits outcome in both directions. Neither in itself decreases expected costs.

Northwest Power Planning Council 76 Risk Mitigation: Optionality Long-term flexibility Start-up and shut-down speed and flexibility Demand reduction Mothball and delay flexibility Operational and administrative control, independence Sizing flexibility (capital cost flexibility) Short-term flexibility Dispatchability, if fixed cost component is small Demand curtailment

Northwest Power Planning Council 77 Risk Mitigation: Hedging Long-term hedges Independence from fuel price Resource diversity High availability and proven technology Reliable technology Cash flow: how and when capital is committed (complex) R&D Short-term hedges Diversity of fuels Reliability of resource and reduced maintenance

Northwest Power Planning Council 78 Which Risks Does the Prototype Address? We may need greater richness in the description of variables, such as separate uncertainty forecasts for each fuel We may need less richness in other areas, such as the subperiods (on- and off-peak) we chose New risk mitigation issues that have arise since its inception Multiple regions and transmission congestion Planning flexibility DSI load response Credit risk/long-term availability Availability of new technologies More detailed price behavior (jumps, etc.) Background