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EXTRACTING VALUE FROM VOLATILITY: INVESTORS NEED TO EMBRACE VOLATILE ENERGY MARKETS, NOT FEAR THEM

Consumers, power providers and investors have all benefited from the increase in renewable power that is lowering wholesale electricity costs in energy markets nationwide. But the fast growth in renewables has also increased something that energy investors traditionally dislike: volatility.

In my previous article I showed why investing in flexible capacity is already generating profits in the relatively volatile real-time market, moving beyond the “day ahead” logic of former power plant investments.

It’s important now to go one step further and look at volatility not as a condition that investors must fear—but one that they should embrace as a perfect opportunity to profit using flexible assets. It’s impossible to know in advance when the sun is going to shine or the wind is going to blow. But with flexible generation capacity, utilities are harnessing that volatility by reacting quickly when price spikes occur, or shutting down gas plants when the price drops, saving investors and consumers millions of dollars in the process.

To better understand energy investors’ changing perception of volatility—that it can actually help them, rather than hurt them—it’s useful to draw a comparison with investments in the stock market. Say, for example, you purchase a stock for $100 with an annual standard deviation of $20. This means that throughout the year, there is a 67% probability (one standard deviation) the stock will be worth somewhere between $80 and $120, and a 95% probability (2x standard deviation) that the price will be between $60 and $140, depending on fluctuation. If you want to sit 10 or 20 years on your investment, that type of volatility isn’t so important to you. But if you’re actively playing the market, buying and selling at a daily or even a minute-to-minute pace, volatility is key: the greater the volatility, the riskier the investment. A stock that you buy for $100, for instance, might have a standard deviation of 80, making it four times riskier; this means you could end up with as much as $260, or as little as negative $60 during the year.

The same risk metric applies to current energy markets, though this is something many investors still haven’t gotten used to. In traditional energy markets, before renewables began playing such a significant role, investors sought predictability and were faced with minimal volatility in energy prices. Because the cost to produce electricity was relatively predictable over five- and 10-year periods, power providers ran their plants at baseload mode while paying little concern to the hourly changes in the price of power. In those times, all that mattered was the average price to produce power across the year. If the average cost was $50 per MW/hour and your running cost was $30 per MW/hour, you came away with a healthy $20 spark spread.

Read more about spark spread in Wikipedia.

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   Matti Rautkivi

   Sales & Marketing Director,
   Wärtsilä Energy Solutions
   
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Read more about how real time markets work in our infographic

 





Read more about how real time markets work in our infographic

Today, with renewables rapidly replacing traditional gas baseload power, things look radically different—in a word, more volatile. Because of so much solar, wind and other clean forms of power entering the market, there are a lot more hours in the day, and night, when the price of energy drops low. In some cases the price even becomes negative, like in Texas at nighttime, when strong winds produce lots of power, energy demand is low, and inflexible gas- and coal-powered plants nonetheless continue generating power. Likewise, at unpredictable moments when the sun isn’t shining and the wind isn’t blowing, the price of energy shoots up high. We’ll be seeing more of this type of price fluctuation across North America as the use of renewable power steadily increases.

Using old, inflexible assets in these volatile conditions can hurt your profit margin. Likewise, the higher the volatility, the more value you can extract using flexible power generation because you’re able to react quickly to the price spikes and shut down your plant at a moment’s notice, saving a significant amount of money. In this sense, flexible capacity isn’t just an insurance against volatility—it’s also an extremely effective way to create value from volatility. Returning to the stock market comparison, flexible power generation is like having a tool that enables you to buy and sell stocks at just the right moment: when the lows and highs are in your favor.

Case in point: Alberta, Canada. Evidence shows that during a volatile year, a flexible generation asset is already able to earn a better margin. We have analyzed this, for instance, in the Alberta energy-only market in Canada, a market that is quite volatile by nature. The market analysis looked at the profitability of a flexible gas asset over the next 20 years. The basis of the price forecast for the analysis was based on the average monthly prices of energy. As said before, we need to analyze flexible asset with more granular price information. Therefore, we generated hourly price forecasts based both on a high volatile price pattern (2012) and a low volatile one (2014). The result: the average price over a year was exactly the same with both price series, but the price pattern varied according to the historical price pattern. Interestingly, the high volatile price pattern provided an 18% internal rate of return for the flexible power plant investment, while with the low volatile price pattern (2014), the IRR number was only 12%. So, the more volatile price pattern provided a higher return for flexible plants.

The example of Alberta is the first tangible, concrete proof of value extracted through flexible assets amid volatility. Yet despite the evidence, many investment analyses today still focus more on the average price of energy, measured over the course of the year, than on the actual price patterns that change on a daily or even hourly basis. As demonstrated in this webinar, those analyses are outdated, impractical and no longer profitable. Volatility always translates into some element of risk. But by investing in flexible power generation, you hedge against that risk and turn it into profit. Now, it’s all about reacting to the price changes, and the technology that exists enables you to do it. The more renewable power enters the grid, the more volatile energy markets will become. By investing in flexible capacity today, you are already profiting from that transition.




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