Title: Flexibility and Technology Choice in Gas Fired Power Plant Investments

Authors: Erkka Näsäkkälä, Stein-Erik Fleten

Date: February 11, 2005

Status: Review of Financial Economics, Vol. 14, No. 3-4, 2005, pp. 371-393.

Keywords: Real options, spark spread, gas fired power plants, investment flexibility

The value of a gas fired power depends on the spark spread, defined as the difference between the price of electricity and the cost of gas used for the generation of electricity. We model the spark spread using a two-factor model, allowing mean-reversion in short-term variations and uncertainty in the equilibrium price to which prices revert. We analyze two types of gas plants: peak and base load plants. A peak load plant generates electricity when spark spread exceeds emission costs, whereas a base load plant generates electricity at all levels of spark spread. A base load plant can be upgraded to a peak load plant. First, we find the upgrading threshold for a base load plant. The upgrading threshold gives the optimal type of gas plant as a function of spark spread. Second, we calculate building threshold for the investment costs. When the investment costs are below the threshold it is optimal to build the plant with the previously solved optimal technology. In the numerical example, we illustrate how our model can be used when investments in gas fired power plants are considered.