Incorporating Operational Characteristics and Start-up Costs in Option-based Valuation of Power Generation Capacity

We describe a stochastic dynamic programming approach for “real option” based valuation of electricity generation capacity incorporating operational constraints and startup costs. Stochastic prices of electricity and fuel are represented by recombining multinomial trees. Generators are modeled as a strip of cross commodity call options with a delay and a cost imposed on each option exercise. We illustrate implications of operational characteristics on valuation of generation assets under different modeling assumptions about the energy commodity prices. We find that the impacts of operational constraints on real asset valuation are dependent upon both the model specification and the nature of operating characteristics. Subject Classifications: Finance: asset pricing, investment. Natural resources: energy. Probability: diffusion, stochastic modeling.