Flexibility and Technology Choice in Gas Fired Power Plant Investments

The value of a gas fired power plant depends on the spark spread, defined as the difference between the unit price of electricity and the cost of gas. We model the spark spread using 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. The first type is a base load plant, generating electricity at all levels of spark spread. The second type is also a base load plant from the outset, but can be upgraded, at a cost, to a peak load plant generating electricity only when spark spread exceeds emission costs. We compute optimal building and upgrading thresholds for such plants when the plant types are mutually exclusive. Our results indicate that selecting a project which is first profitable leads to a nonoptimal investment policy, and that increase in short-term volatility preempts upgrading whereas increase in equilibrium volatility delays upgrading.