Coal gasification in a deintegrated electricity industry

Coal gasification in a deintegrated electricity industry Edward Kahn and Steven Stoft Th& paper examines coal gasification in the context of a regulated utility purchasing power from an independent power producer (IPP). It outlines various contractual approaches that might be used to achieve coordination between the profit motive of the IPP and the desirability of limiting the potential escalation of natural gas prices through a backstop technology. These approaches are formulated as options. A numerical method to value the gasification option is presented. The option value is found to be significant (although uncertain). The transactions costs associated with writing contracts to incorporate the option value are substantial. Vertical integration may handle these issues more easily. Keywords:Competitive bidding; Coal gasification; Options

This paper examines coal gasification in the context of the diminishing extent of vertical integration in the electric power industry. Specifically, we shall consider the problems of introducing coal gasification for a regulated utility purchasing power from an independent power producer (IPP). The basic tradeoff between vertical integration as a method of organizing industry, and a more decentralized market structure, involves gains from competition versus losses of coordination.1 We consider this broad set of issues from the particular angle of the adoption of coal gasification. When fuel choices are made for power generation, the decisions have long-term consequences, because fuel-switching capability is limited. In recent years, decisions on the choice of fuel for power generation have increasingly turned toward natural gas, both in industrialized countries such as the USA and in developing countries. This is due both to the low

Edward Kahn and Steven Stoft are with the Lawrence Berkeley Laboratory, MS 90-4000, 1 Cyclotron Road, Berkeley, CA 94720, USA. 46

cost of natural gas in many settings and the desirable cost and efficiency properties of the new gas turbine technology that is becoming commercially available. 2 The main economic uncertainty associated with natural gas is the possibility that real fuel-cost escalation may make the choice of gas-fired electricity uneconomic ex post. The principal technology available to limit the escalation of gas prices once the choice has been made to use natural gas is coal gasification. The role of this technology as the 'ultimate cap on gas prices' has long been recognized. Most discussion of this role, however, has focused on the scenario in which investment decisions by vertically integrated utilities are involved, rather than some form of de-integrated private power market. 3 Here, we consider the issue in a setting based on competitive bidding by independent producers for long-term electricity-supply contracts. Competitive bidding of this kind is becoming the dominant mode for deregulation of electricity at the wholesale level in the USA. The differences between the vertical integration and competitive bidding scenarios are significant. They involve both contractual questions and valuation questions. Both sets of issues arise because the value of coal-gasification technology under current market conditions is largely associated with its flexibility. As long as natural gas prices are low, the extra costs of gasification are not currently economic. At some point, however, this is likely to change. At such a point, if the utility were making the investment, it would simply install the equipment and realize its benefits for ratepayers. In an independent-producer setting, this becomes more complex. At the time when the benefits of gasification to a utility's ratepayers are greatest, independent producers will have substantial leverage. The utility may or may not be able to induce a non-utility generator to install the equipment. Without some contractual commitment by such generators, there is no guarantee that reasonable agreement can be reached. Therefore, the option for a commitment to gasification must be embedded in contractual language, and the bid-selection process must account 0957-1787/94/010046-09 © 1994 Butterworth-Heinemann Ltd

Coal gasification in a de-integrated electricity industry for the value long before it may be necessary to exercise the commitment. This paper is organized in the following fashion. The next section - Coal gasification in the independent power market - examines contractual issues. It briefly reviews the experience to date with coal gasification in the independent power market, and outlines the principles that need to be embedded in efficient contracts with non-utility generators to make the gasification option viable. The following section - Determining coal-gasification option value: a numeric approach - focuses on the key issue in bid evaluation, determining the value of the gasification option. Numerical techniques are presented to illustrate how the valuation should be determined. Conclusions are offered in the final section.

Coal gasification in the independent power market Experience to date Coal-gasification technology has had very little success in the independent power market. Although several projects have negotiated power-purchase agreements with utilities based on this technology, to date none of these has progressed in the development process. 4 In addition, there have been projects proposed by vendors that have not advanced beyond the discussion stage. Most actual experience with gasification has been gained through projects subsidized by various governments. There has been substantial discussion of gasification as an option for non-utility gas-fired combinedcycle projects, but most of this discussion has failed to materialize into actual contractual language. A representative example of the option framework is the proposal of Cogen Technologies to Baltimore Gas and Electric (BG&E). This developer of gasfired combined-cycle cogeneration projects agreed in principle to use gasified coal in the future 'should there be an economic advantage (to B G & E ratepayers) to converting fuels'. 5 An offer of this kind is meaningless without specific contractual language. The entire dispute between Cogen Technologies and B G & E represented by this case, however, involves contractual issues. There are two contracts that have explicit provisions for coal gasification. They are both with Virginia Power, and are Doswell Limited Partnership, and Richmond Power Enterprises (formerly SJE Cogeneration). Both of these are operating projects. We characterize the relevant contract clauses in each case. Doswell involves a post-commercial operation op-

UTILITIES POLICY January 1994

tion that can be exercised solely at the seller's choice. The option is not designed to substitute for the project capacity committed to burn gas, but is strictly a supplement: it applies only to capacity above the originally contracted quantity. The pricing terms are unrealistic. The capacity payment would be $205/kW-yr for the first 15 years and $118 thereafter. This is much lower than prices being paid to pulverized coal projects, which are typically between $300 and $400/kW. 6 Richmond Power Enterprises has a contractual option to use gasification technology at its own choosing, subject to approval of its plans by Virginia Power. The language describing the choice strongly suggests that this is a choice to be made, if at all, b e f o r e c o m m e r c i a l o p e r a t i o n . T h e r e does not appear to be any intention of using gasification as a backstop on the price of natural gas. The contract language seems more directed at security of fuel supply issues. The pricing terms are identical to those in Doswell. In summary, gasification has not yet found a place in the private power market. Its natural role under current expectations is as a backstop option to limit gas price increases. Neither Doswell nor Richmond Power Enterprises offers much of a model for such a role. In the next section we examine the kinds of contractual and valuation issues that must be settled to define a useful, efficient and realistic model for a backstop option. Contracts to allow exercise o f the gasification option Before exploring contractual issues, it is useful to examine briefly three contractual forms designed to facilitate the timely exercise of the gasification option. We shall contrast these three approaches with the contracts that are currently typical in the industry, an approach that we shall call 'standard'. This approach simply relies on the profit motive of sellers and is, according to the following argument, not likely to produce the desired outcome. In the standard case, the seller would install gasification when fuel prices were sufficiently high in the hope of being able to 'sell' his own gas to his generating plant at a high enough price to more than recover the capital costs of the gasification plant. The price of this gas would be limited by two factors. First, the standard contract would limit the price to some index of available natural gas; and second, the utility's ability to limit dispatch could further restrict the price charged. Assuming that the seller's project is dispatchable, which is now the norm in this market, 7 the project would be frequently curtailed if price were set much above the utility's price for

47

Coal gasification in a de-integrated electricity industry other fuels. Therefore, the seller would have to share the gasification benefits with ratepayers by lowering the price enough to be dispatched for a large number of hours per year. This is in the seller's interest, as gasification is only economic if the equipment operates in the baseload mode: that is, most of the year. The seller must pick a price that will both give him profits and assure baseload dispatch or the near equivalent. These two motives conflict. The seller's uncertainty about what price would yield what dispatch makes this strategy risky. Because the standard contract typically makes the producer fairly indifferent to his level of dispatch, and fully compensates him for the cost of fuel, there is no pressure on producers to turn to gasification in a high-priced gas market; there is only the lure of extra profit. This lure is tempered by the possibility that gas prices will not remain high enough for the producer to acquire full dispatch at a sufficiently high price. Thus there is considerable danger that the chance of excess profits will materialize in the form of a considerable loss. Since we believe that producers and investors are fairly risk-averse, we do not expect the gasification option to be voluntarily exercised in any but the most extreme gas markets. Contract approach one: the right to sell. One alternative contract approach would be simply to require that an independent producer purchase gas from the utility whenever the utility chooses. This would give the utility the complete power to control the gasification technology, and force the purchase of its output. This kind of compulsion is not always feasible. In such a scenario, the utility would either have to install the equipment on the independent producer's site, or deliver it through a pipeline. Neither alternative is particularly satisfactory. Not all sites are suitable for this kind of installation. Differentiating characteristics of sites are discussed below. The pipeline alternative is also problematic. Simply blending synthetic gas with pipeline gas is not feasible because their characteristics differ, particularly in Btu/ft 3 (kJ/m3). A dedicated pipeline is possible, but may not be economic. A l t h o u g h the c i r c u m s t a n c e s in which this approach is feasible are limited, it is the most straightforward contractually, eliminating most of the problems that will shortly be discussed with regard to the other approaches. It is also the approach that maintains the maximum amount of vertical integration. Contract approach two: the right to build. The second and third approach both require the produc-

48

er to have a site available for a coal-gasification facility. This is no small requirement, given environmental laws and siting problems, and as we shall see it can be difficult to know, years in advance, whether a particular site is in fact feasible. That will be discussed later. For now we simply define the second approach to be a contract that specifies that the utility can, at its discretion, build a gasification facility on the producer's site, and that the producer will from then on buy all of its fuel from the utility. This approach solves the location problems associated with the first approach, and the compensation problems associated with the third approach. But it ties the utility closely to the independent producer, and this may exacerbate the 'end-effects' problems that are discussed later. Contract approach three: the right to require conversion. The third approach is to specify that the producer must build a gasification facility whenever the utility requests it. This keeps the utility at arm's length, but poses very difficult compensation problems. Unlike the cost of the generating facility, the cost of the gasification facility cannot be determined through the bidding process. Thus the level of compensation must be established through some form of negotiation, which may itself be a very costly legal process. Issues facing realistic option contracts Having specified the basic contractual possibilities we turn to the issues and problems that must be successfully overcome by any of these in order to make coal gasification function effectively as a backstop option on the price of natural gas. In this section we discuss what the threshold requirements are for a workable contract, and the choices that need to be made in implementing such contracts. The economic framework for assigning value to bidders who offer a credible gasification option is discussed below. Buyer's choice o f when to exercise. As the discussion below will indicate, one of the most difficult aspects of the backstop option is deciding when to exercise it. If it were not for this fact, one would clearly want the utility to make this choice, as its purpose is to benefit the ratepayer. However, current economic thinking suggests that the party with superior information (or any other advantage in making a correct decision) should sometimes make the decision even though it may not initially have the incentive to make it correctly. Thus if the IPP were better equipped to make the decision, it might be

UTILITIES POLICY January 1994

Coal gasification in a de-integrated electricity industry optimal for the utility to find a way of motivating it to use its information and abilities in the ratepayer's best interest. Typically, the ratepayer would have to pay some information rent to the IPP in the process, but the net result could still be superior from the r a t e p a y e r ' s perspective if the IPP were skilful enough at making the decision. As we do not believe that IPPs have significantly better skills and information with which to make the choice of implementation timing, we think it is best to give this decision to the utility. All three of the alternative contracts described above do this, but the third contract needs additional language to ensure compliance. The first two types of contract leave the supplier little scope for impeding the implementation of gasification and little reason to want to. But the point of the third contract is to require the IPP to do something that it would probably not otherwise do. The process of building a gasification facility is long, complex, and involves considerable government regulation, and so there are numerous opportunities for it to be subtly hampered. Also, at the time when gasification is most needed (when gas prices are high), the utility will have the least bargaining power. Failure to recognize these simple realities makes the option in the Doswell contract, for example, essentially worthless to utility ratepayers. To give the seller's commitment some sanction, it would be advisable to write into the power-purchase contract a penalty clause for failure to comply. The sanction might be termination of the agreement, or forfeiture of a bond that the independent producer would have to post. The cost of such a bond would inevitably be paid for in the contract price, so it might not be worth while insisting upon such a condition. The choice of sanction is a design issue for specific contracts. The need for a sanction mechanism is a threshold requirement to help ensure commitment. Suitability o f the site. Appropriate infrastructure must be available or the option cannot be exercised. Gasification technology has certain minimum siterelated requirements. The infrastructure requirem e n t s include: c o a l - t r a n s p o r t a t i o n capability, adequate site area for fuel storage, and access to the water required for the gasification process. These capabilities must be assessed in advance, at the time of project selection. Site suitability is essentially a credibility issue. If a bidder offers the gasification option, but does not have a suitable site, he may try to plead that any failure to comply at the time the option should be exercised is an excusable fault - a

UTILITIES POLICY January 1994

force majeure - and therefore no sanction should apply. In such a situation, the bidder may achieve competitive advantage in the project selection by the offer to gasify, but as the offer was not really legitimate, the utility ratepayers ultimately realize no value. Site suitability issues can be expected to differentiate the bids. At the bid evaluation stage, utilities must make an assessment of how suitable a given site may be for gasification. Differences in suitability are equivalent to differing probabilities of successful exercise of the gasification option. The expected value of the gasification option in a particular bid is the value of the option assuming that it is exercised multiplied by the probability that it can be exercised. End-effects and the length o f contracts. This is a subtle issue, which involves a mismatch between the lifetime of the gasification equipment and the term of the power sales contract. The option is not likely to be exercised in the first few years of the power sales agreement term, as the gap between backstop costs and current gas prices is large. If the power sales agreement is for a 20-year term, the economic lifetime of the gasification facilities is 20 years, and the optimal conversion time occurs in year 10 of the power sales agreement, there is a mismatch of 10 years. At the end of the power sales contract there is still an economically viable gasification facility that must be amortized for another 10 years to recover its capital costs. All three of the contracts face this same problem but in slightly different forms. With the first two contracts, the utility may find the gasification facility held hostage by the IPP in the negotiations for renewal of the power contract, because without such a renewal, there may be no reasonable place to sell the synthetic gas. One solution to the end effects mismatch is to extend the power sales agreement until it matches the unamortized lifetime of the gasification facilities. The power generation equipment, however, may need upgrading or partial replacement. Simple extensions of the capacity price may or may not cover these costs. If the potential end-effects mismatch is anticipated, bidders can offer terms for extending contracts that may be evaluated during the initial bid-selection screening. If the gasification equipment is to be owned by the independent producer, some kind of power sales contract extension may be necessary. Alternatively, if the utility owns the gasifier, it may replace the independent producer with another developer or with its own equipment, or it may

49

Coal gasification in a de-integrated electricity industry

extend the power sales contract as in the previous case. Utility ownership may provide greater flexibility to manage the end-effects mismatch.

Determining coal-gasification option value: a numeric approach The need to value the gasification option

Sellers will not offer the gasification option unless it gives them a competitive advantage. The extent of this must be known at least approximately when offers are made so that the sellers can incorporate the information in their bid. Even if the utility wanted to require the gasification option as a threshold condition of bidding, it would still have to perform some valuation. The reason is that it would need to distinguish a m o n g bids by the probability of being able to exercise this option, i.e. site suitability issues, and thereby estimate the expected benefits of the option offered by each bidder. Therefore, some kind of valuation effort is necessary. Specifying the p r o b l e m . In this section we estimate

the value of a coal-gasification option by means of a Monte Carlo simulation of future gas prices. There is an analytic literature addressing similar problems, ~ but it typically addresses problems in which the value of the asset being options follows a geometric Brownian motion (e.g. see Pindyck, cited in R e f 8). As such a random process has the property that its step size is proportional to its value, its value (which is typically positive) is prevented from ever changing sign. Since the value of a coal-gasification facility starts negative and later becomes positive, it cannot be modelled by such a process. 9 For this reason we have chosen to t a k e a d y n a m i c p r o g r a m m i n g approach to the problem and to estimate the solution numerically. We do this by simulating the future price of gas, and the decision and construction process for a coal-gasification facility. The heart of the simulation is the generation of r a n d o m gas-price scenarios. We assume that gas prices follow what is known as geometric B r o w n i a n m o t i o n with drift. This is a special type of Ito process with the following two properties: (1) the expected value of such a process increases by a constant percentage rate per unit time, which we call rt, and (2) the variance increases at a constant percentage rate per unit time, which we call o z . We begin with some terminology and definitions characterizing continuous random processes. The Weiner process, represented by shorthand dz, is the basic random process from which we construct all

50

others used in this discussion. During a time interval dt it will change by some amount that we also represent by dz. The expected size of this change is equal to the square root of dt. This is natural, because this means that variance, E(dz2), increases linearly with time. (Recall that the variance of the sum of n identical random variables is just n times the variance of one such variable.) The standard Weiner process starts at zero and after one unit of time has a variance of 1, and still has a mean of zero. If we take the exponential of the Weiner process we have a process that starts out with a value of 1 (e °) and never goes negative. For this process (call it dx), the amount of change is proportional to the value of the process; thus E(dx 2) = x dt. Since a price never goes negative, this type of process is useful for modelling prices. In order to model a price with a non-zero expected growth rate, we just add a linear drift term, g dt, to the Weiner process before we exponentiate it. There are two ways to construct such a process. The first is to construct a linearly transformed Weiner process and then exponentiate it. The second is to construct an Ito process in which the step size depends on the current magnitude of the process. These approaches can be expressed as follows: 1. x = e y, 2. dx =

dy = 0¢ + o dz

o~ + ~

x dt + ~J x d z

H e r e , dz represents the standard Weiner process: E(dz) = 0, E(dz 2) = dt These are simply different descriptions of the same process, which has a growth rate o f g = 0~ + 02/2 and a standard deviation per unit time of o. Note the contribution of the rate of variance to the expected growth rate. We have chosen the first representation as the basis for our model. Since numeric methods require the process to be implemented in discrete time, the gas-price stochastic process has actually been implemented as follows: x , + A t = xt +

g--~

dt + o N ( O , 1 ) X / ~

P, = e x,

UTILITIES POLICY January 1994

Coal gasification in a de-integrated electricity industry

Here, g is the expected growth rate of the gas price, o is the coefficient of variation that accumulates during one year, N(0,1) is a standard-normal random variable, and dt is the time resolution of the simulation (typically half a year). We now turn to the specification of the gasification project and of the option itself. We assume first that the utility is under a 20-year contract to purchase power from an IPP. If the utility has an option to gasify, then it can direct the start of construction at any time during the 20-year contract. If it does not have such an option then it must wait until the end of the contract period before starting construction. After construction starts there is a delay (of 2.5 years in the base case) before production is achieved. We do not model the fixed and variable costs separately but simply assume that the gas produced is produced at a fixed backstop price from then on. To realize an option's value it is necessary to follow the optimal rule for exercising that option. It is well k n o w n that when a p r o b l e m is timeindependent, as this one is, m the optimal exercise rule is simply to wait for the value of the optioned asset to reach a particular threshold and then to exercise the option. Since the value of the project is completely determined by the price of gas, that rule is equivalent to waiting for the price of gas to reach a certain level, which we shall call the exercise price, X. When the price of gas exceeds this critical level it becomes economically advantageous to exercise the option to install gasification technology. Determining the optimal exercise rule is an intrinsic part of finding the option value and thus, as argued above, has not been handled by the literature on analytic solutions; thus we must take a numeric approach. This simply amounts to trying 15 values over a plausible range of exercise prices and picking the one that yields the highest value. ~ One might assume that the optimum exercise price would simply be equal to the backstop price, but this is not so, because exercising an option destroys its option value. If, when the price of gas first equalled the backstop price, one had to decide once and for all whether or not to implement coal gasification, one would choose to implement, because the price would be more likely to go up than to go down. However, when one is faced with the choice of implementing now or waiting another month to decide, then the proper choice is to preserve the option value and wait. In another month, one might discover that the price of gas had fallen and be glad that the investment had been postponed. However, when the price of gas gets sufficiently high, typically 20-100% above the back-

UTILITIES POLICY January 1994

stop price, then the value of gasification overtakes the value of having the option and it pays to exercise. We do not have to rely on our intuition to confirm this fact, but can test various exercise prices to find the one that makes the option most valuable. We always do this in order to find the optimal exercise rule, and we always find that optimal exercise occurs well above the backstop price. (In the limiting case where gas price is deterministic, the optimal rule would be to exercise just far enough below the backstop price so that by the time the gasification facility was complete, gas price would equal backstop price. For reasonable parameters this effect never dominates the option value effect.) Table 1 displays the base-case values of all of the inputs to the simulation model. Table 2 reports the results of simulations for six different sets of input variables. For each set of variables the simulation was run 3 000 000 times, and so the calculation of option value was made for this many different gas price series. Fifteen different exercise prices were tried and either a quadratic or cubic was fitted to the results to determine the optimal exercise price and the option's value. The results are reported in the last four columns. Both option value and total fuel cost are present discounted values (PDVs) over the 20-year life of the power-purchase contract. ~2 As can be seen, option values range from 5% to 23% of the total PDV of fuel costs: a quite substantial sum. Note that by the very nature of options, their value is an average of many possible outcomes, most of which have values very different from the expected option value. In the present case, the realized value of the option is usually zero, but in a small fraction of cases its value is large. Finally, in an even smaller fraction, its value is negative. The zero values are the result of gas prices staying low enough that the option is not exercised during the 20-year contract life, while the negative values arise when the price increases rapidly, causing the option to be exercised, and then falls again so that exercise turns out not to have been desirable. It should be noted that the choice of discount rate does not affect the option value as a fraction of PDV fuel cost; a higher discount rate Table 1. Base-case values for simulation model.

Riskless consumer discount rate, r Growth rate of gas prices, g Standard deviation/year of gas prices sd (%) Gas price at time 0, Po ($/MBtu) Backstop price, BP ($/MBtu) Contract duration, T (years) Construction delay, delay (years)

0.03 0.02 0.23 3.0 5.0 20 2.5

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Coal gasification in a de-integrated electricity industry Table 2. Simulation results: base-case and sensitivities.

r

g

sd

BP

delay

Exercise price

Option value

Total fuel cost

Value as percentage of cost

0.03 0.05 0.03 0.03 0.03 0.03

0.02 0.02 0.04 0.02 0.02 0.02

0.23 0.23 0.23 0.115 0.23 0.23

5 5 5 5 6 5

2.5 2.5 2.5 2.5 2.5 3.5

8.5 7.7 7.2 5.9 10.1 8.3

6.5 5.1 15.2 2.6 4.9 6.9

54.5 45.5 66.3 54.5 54.5 54.5

12 11 23 5 9 13

lowers the absolute value of the option and the fuel cost, but doesn't affect the ratio significantly. The two most dramatic effects shown in Table 2 are produced by a change in the growth rate (g) and a change in the uncertainty of gas prices (sd). 13 The effect of a higher growth rate is obvious. The effect of a lower rate of standard deviation is subtle, but can easily be understood by considering the case where sd = 0. In this case, the assumed growth rate (2%) is insufficient to bring the price of gas above the backstop price in time to make gasification viable. However, when sd > 0, there is some chance of finding the price of gas well above the backstop price before the end of the contract, and in this case gasification can be expected (in the statistical sense) to be profitable. As the option is exercised only in such a circumstance, and is ignored in less favourable circumstances, any sd > 0 guarantees a positive option value. As sd increases, so does the likelihood of finding the exercise of the option to be profitable. It might seem that the option values listed above are unrealistic in practice because they depend on using the optimal exercise rule, and that rule depends on several poorly known parameters. Thus one could never expect to use the optimal rule. While this is so, the problem is smaller than might be anticipated, because at the optimum the option's value is completely insensitive to the exercise price. Moreover, in our base case, any exercise price between 6.8 and 10.8 will produce an option value within 10% of the maximum achievable value.

Conclusions We have shown that the option value of gasification, though quite sensitive to parameter specification, is economically significant. This sensitivity is unfortunate, but some estimate of value is necessary for the 'unbundling' of project attributes that is a necessary part of deregulating markets. ~4 This raises the question of whether the new deintegrated electricity market structure can efficiently handle the problem of timely conversion to gasification technology. In the process of evaluating gasification options

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we have shown that the optimal exercise price is probably well in excess of the backstop price of gasified coal. In our base case the optimal exercise price should be at least 35% above the backstop price. This point has significance well beyond the scope of this paper, as it implies that neither utilities nor IPPs should invest in gasification technology until gas prices reach far beyond the backstop price. We have outlined three economic approaches to incorporating the gasification option in the competitive bidding setting that characterizes the competitive market structure in the US electricity industry. But economic issues alone may not be determinative when it comes to exercising the option to gasify; instead, environmental or siting constraints may prevent the contractual clauses from being invoked. This would make the value of a gasification contract zero. Estimating the probability that such constraints will be operative many years in the future is difficult at best. None the less, it would be unrealistic to fail to account for such a possibility when evaluating the option to gasify. Vertical integration may handle these issues in a better fashion than competitive bidding. The transaction costs associated with valuing the option and writing contracts to incorporate it are not small. The opportunities for error are not negligible. It is possible that, in more developed competitive markets for electricity, many of the contractual and valuation problems discussed here will be mitigated. In the USA, the forces creating competition are growing stronger. The relatively small size of utility service territories limits the market for independent electricity producers. As access to the transmission network increases, the market will get broader and may allow for less contractual rigidity. In the current US system, long-term power-purchase contracts lie at the heart of the capital-formation process. 15 In broader markets, it is possible that other mechanisms will materialize. Under current conditions, however, coal gasification as a backstop option to control gas prices will have to be implemented within a contractual framework. If the efficiency benefits of this procedure are sufficiently large, the transactions

UTILITIES POLICY January 1994

Coal gasification in a de-integrated electricity industry

costs described here will be worth while. Finally, the problem of motivating the gasification decision in a more decentralized fashion remain unsolved. The work described here was funded by the Deputy Assistant Secretary for Coal Technology, US Department of Energy, under Contract No. DE-AC03-76SF00098.

~For alternative approaches to restructuring the electricity industry see B. Tenenbaum, R. Lock and J. Barker, 'Electricity privatization: structural, competitive and regulatory Options', Energy Policy, Vol 20, No 12, 1992, pp 1134-1160. The trade-off between decentralization and vertical integration is treated in O. Williamson, The Economic Institutions of Capitalism, The Free Press, New York, 1985. eThe growing role of gas-fired electricity in the USA and Canada is described in M. van Egteren, 'Natural gas for electric power generation: advantages, availability and reliability', Utilities Policy, Vol 3, No 2, 1993, pp 145-153. Its role in developing countries is described in S. Meyers, N. Goldman, N. Martin and R. Friedman, "Prospects for the power sector in nine developing countries', Lawrence Berkeley Laboratory Report No. LBL33741, 1993. The advances in gas turbine technology are characterized in R. Williams, and E. Larson, 'Expanding roles for gas turbines in power generation', in Electricity: Efficient End-Use

and New Generation Technologies and Their Planning Implications, T. Johansson, B. Bodland and R. Williams, eds., Lurid University Press, 1989, pp 5113-553. 3The backstop role of coal gasification is described in T. Moore, 'Natural gas for utility generation', EPRI Journal, Vol 17, No 1, 1992, pp 4-15. Thc role of gasification in vertically integrated electric utilities is discussed in Fluor Daniel Inc., Phased Construction of Gasification-Combined Cycle Power Plants, Electric Power Research Institute, EPRI GS-7224, 1990. 4Two projects of this kind are: (1) Towner Electric agreement with Public Service Electric and Gas (Newark, New Jersey) for a 440 MW facility, contract dated 1 February 1991; and (2) Virginia Iron Industries 211J MW facility selected by Virginia Power in July 1990 as a result of its August 1989 RFP. This project has not concluded a power-purchase contract as of March 1, 1993 (see Virginia Power, Annual Filing Pursuant to Case No. PUES00102, 1993). ~Sec R. Shanker, Testimony on behalf of Cogen Technologies in

Maryland Public Service Commission, Case No. 8241, Phase II, 1991. 6See E. Kahn, 'Risks in independent power contracts: an empirical survey', The Electricity Journal, Vol 4, No 9, 1991, pp 30-45. 7See E. Kahn, C. Marnay and D. Berman, 'Evaluating dispatchability features in competitive bidding', IEEE Transactions on Power Systems, Vol 7, No 3, 1992, pp 1259-1265. ~See H. Chao and R. Wilson, 'Irreversible investment and the option value of flexible substitutes', Stanford Business School working paper, 1991; E. Crousillat and S. Martzoukos, 'Decision making under uncertainty - an option valuation approach to power planning', World Bank Energy Series Paper No. 39, 1991 ; S. Martzoukos and W. Teplitz-Sembitzky, 'Optimal timing of transmission line investments in the face of uncertain demand: an option valuation approach', Energy Economics, Vol 14, No 1, 1992, pp 3-10; R McDonald and D. Siegel, "The value of waiting to invest', Quarterly Journal of Economics, Vol 101, 1986, pp 707-727; and R. Pindyck, 'Irreversibility, uncertainty and investment', Journal of Economic Literature, Vol 29, 1991, pp 11101148. ~The gas price itself follows a geometric Brownian process with drift, but we are not considering an option to buy a unit of gas, we are considering the option to buy a gasification plant. When gas prices are sufficiently low the value of such a plant is clearly negative since it can be expected to wear out before it produces any gas at a cost below the market price of gas. Thus the value of a plant cannot be viewed as following a geometric process. "qf we are told the price of gas at a certain time, we can computc all economic variables without needing to know the particular time at which the price occurred. ]~We actually fitted a quadratic to the 15 points and used its maximum as an estimate of both the optima exercise price and the option value. This improves our estimate and removes the upward bias inherent in selecting the highest value. ~2This assumes no explicit solution to the end-effects problem. We simply calculate the value of the option without treating the cost recovery associated with the investment. ]3The value we use as our base case for sd is taken from a study of the US gas market during the period 1985-1988: E. Teisberg and T. Teisberg, 'The value of commodity purchase contracts with limited price risk', The Energy Journal, Vol 12, No 3, 199l, pp 109-135. 14For an example in a similar spirit, see S. Stoft and E. Kahn, 'Evaluation of front loading in auctions for wholesale power', Utilities Policy, Vol 1, No 1, 1990, pp 28-35. 15See E. Kahn, M. Meal, S. Doerrer and S. Morse, 'Analysis of debt leveraging issues in independent power projects', Lawrence Berkeley Report No. LBL-32487, 1992.

Appendix A simulation model for estimating the value of coal gasification The calculation of the option value p r o c e e d s f r o m year zero to year 60 in half-year i n c r e m e n t s . Two parallel calculations are carried out, one assuming that t h e r e is no option and the o t h e r assuming that t h e r e is. In either case, gasification can be carried out at any time after the expiration o f the 20-year contract. In b o t h cases we c o m p u t e the p r e s e n t value of the cost

UTILITIES POLICY January 1994

of gas over the full 60 years in o r d e r to avoid significant end effects. Both cases use the same r a n d o m price of gas. The price of gas is c o m p a r e d with the prespecified exercise price at each time. The option is exercised the first time the price of gas is higher, or, in the n o - o p t i o n case, construction is u n d e r t a k e n at the first such occurrence after the 20-year contract ex-

pires. A f t e r the option has b e e n exercised, t h e r e is a construction delay of delay years (2.5 years in the base case), after which the price of gas for this case b e c o m e s the b a c k s t o p price, BP. Finally, the present-value cost of gas in the option case is subtracted from the present-value cost of gas in the n o n - o p t i o n case to yield the value of the option. Since the gas price s e q u e n c e is rand o m it is necessary to average the option value for a large n u m b e r of possible gas-price scenarios before an

53

Coal gasification in a de-integrated electricity industry

accurate average value is obtained. In fact, because the distribution of option values is so far from normal, the necessary n u m b e r of runs is unusually high. Typically, we have generated 100 000 scenarios to produce each estimated value. F r o m the above description it can be seen that the calculation of the random gas-price time series is one central problem. Details of the speci-

54

fication of the exercise price are available from the authors.

Generating gas prices The algorithm for generating the gas price index with a starting value of 1 is as follows: x = 0; for (i = 1 to NT)

Ni = Ni-~ + g + N S D pricei = e Ni

X/~-]

f

where N T = 120, the total number of calculation periods; g = 0.02, the growth rate of gas prices; N = a value randomly selected from the standard normal distribution; sd = 0.23, the standard deviation per year of gas prices; dt = 1A year, the length of one calculation period.

UTILITIES POLICY January 1994