The Value of Flexibility in New Power Plant Construction for Municipal Shanghai, ChinaObjectivesRobust Demand Growth in Recent DecadesOptionsCost Model: AssumptionsSample Cost Model: Flex Plant Used to determine net present value (NPV)Decision AnalysisValue at Risk and GainChoosing Best DesignAnnual Localized Demand GrowthBinomial Lattice Analysis“Call” Option in Natural Gas Plant “Put” Option on Coal PlantConclusionsThe Value of Flexibility in New Power Plant Construction for Municipal Shanghai, ChinaValerie J. KarplusESD.71 Engineering Systems Analysis for DesignDecember 17, 2007Objectives• Background – Electricity demand in Shanghai• Analysis of options for capacity expansion:1. Large coal plant2. Large natural gas plant3. Small natural gas plant + expansion option• Tools used:– Decision analysis (NPV, cost-benefit)– Binomial lattice valuation of options• ConclusionCompared directlyRobust Demand Growth in Recent DecadesTotal demand growth approximately 7.9% per year.Requires rapid build-out of new capacity – how to meet demand? How to encourage cleaner power production?Trend in Electricity Demand in Shanghai, P.R. China, 1991-2005y = 2E-66e0.0788xR2 = 0.9852010020030040050060070080090010001991 1993 1995 1997 1999 2001 2003 2005YearDemand in 100 million kWhDemandExpon. (Demand)OptionsPlan 1 – Large coal plant Æ “put-like” option to closePlan 2 – Large natural gas plantPlan 3 – Small natural gas plant Æ “call-like” option to expandAnalysis:- Define assumptions (demand growth, feedstock price, regulation)- Develop cost model- Evaluate value of flexibility• Decision analysis• Binomial lattice valuationCost Model: Assumptions1 – Large Coal 2 – Large NG 3 – Flex NGCapacity 500MW 500MW 300MWCapital Cost $500m $400m $300mExpansion N.A. N.A. $180mHeat Rate 10,900 BTU/kWh 5687 BTU/kWh 5687 BTU/kWhFeedstock Price $1.05/MMBTU $6.05/MMBTU($7.05/MMBTU)$6.05/MMBTU($7.05/MMBTU)O&M Cost $10m $10m $6m (+ $6m)Max Output 3,700m kWh 3,700m kWh 2,200m kWh (+ 2,200m kWh)Period Length 2 x 5 years 2 x 5 years 2 x 5 yearsDemand Growth 350m kWh/yr(450m kWh/yr)350m kWh/yr(450m kWh/yr)350m kWh/yr(450m kWh/yr)Sample Cost Model: Flex PlantUsed to determine net present value (NPV)2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020Year 0123456 78910Capital Cost ($ millions) 300.00 0.00 0.00 0.00 0.00 180.00 0.00 0.00 0.00 0.00 0.00Price of Gas ($/MMBTU) 6.05 6.05 6.05 6.05 6.05 6.05 6.05 6.05 6.05 6.05Fuel Cost ($ millions) 15.48 30.97 46.45 61.93 75.69 91.18 106.66 122.14 137.63 151.39O&M Cost ($ millions) 6.00 6.00 6.00 6.00 6.00 12.00 12.00 12.00 12.00 12.00Price of Electricity (cents/kWh) 8.20 8.20 8.20 8.20 8.20 8.20 8.20 8.20 8.20 8.20Demand (100 million kWh) 4.50 9.00 13.50 18.00 22.00 26.50 31.00 35.50 40.00 44.00Revenues ($ millions) 36.90 73.80 110.70 147.60 180.40 217.30 254.20 291.10 328.00 360.80Net Income, NI = R -C(Cap) - C(Fuel) - C(O&M) -300.00 15.42 36.83 58.25 79.67 -81.29 114.12 135.54 156.96 178.37 197.41Discount Rate 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10Discount Factor 1.00 1.10 1.21 1.33 1.46 1.61 1.77 1.95 2.14 2.36 2.59Annual Discounted Cash Flow -300.00 14.02 30.44 43.77 54.41 -50.48 64.42 69.55 73.22 75.65 76.11NPV -300.00 -285.98 -255.54 -211.78 -157.36 -207.84 -143.42 -73.87 -0.65 75.00151.11Assumptions: Start with 300MW capacity, demand high, price low, build new plant.Decision AnalysisProbability of large losses if demand low, reg.Ability to take advantage of upside limited.Can exercise option to take greater advantage of upside if demand high.Values in millions of dollarsValue at Risk and GainBased on probabilities in decision analysis:Staged natural gas plant allows plant operators to take advantage of upside, minimize downside risks.Coal plant has large potential upside but also large potential downside.Choosing Best DesignUpside potential Æ Coal (Plan 1)Downside minimized Æ Staged NG (Plan 3)NPV Æ Staged NG (Plan 3)Cost-Benefit Ratio Æ Staged NG (Plan 3)(C-B better than NPV for ranking)Project Expected NPV NPV of Cap Ex Benefit-Cost Ratio Plan 1 – Large Coal (500 MW) $ 77.16 $ 500 0.1543Plan 2 – Large Gas (500 MW) $ 60.20 $ 400 0.1505Plan 3 – Phased Gas (300 MW or 600 MW)$ 98.88$ 300 (+$ 112*0.5)E = $ 3560.2778E = probability weighted capital expenditures for phased gas plant based on decision analysis.All values in millions.Annual Localized Demand Growth• Goal: Meet localized demand• Demand is growing year-on-year• Used to estimate year-on-year demand growth in lattice model, summed to obtain cumulative growth in latticeLocalized Annual Demand Growthy = 0.3577e0.1862x-10123456135791113One Year Period, 1992 to 2005Demand 100 million kWhDemandExpon. (Demand)• Start value assumed is average of 3.0 100 million kWh• Evolution described by lattice of probabilitiesBinomial Lattice AnalysisEvolution of Demand Probabilities0.000.100.200.300.400.500.600.700.800.901.000.01 0.10 1.00 10.00 100.00 1000.00Demand (100 million kWh)Probability201020112012201320142015201620172018201920202010 2011 2012 2013 2014 2015 2016 2017 2018 2019 20201.00 0.71 0.51 0.36 0.26 0.18 0.13 0.09 0.07 0.05 0.030.29 0.41 0.44 0.42 0.37 0.32 0.26 0.21 0.17 0.130.08 0.18 0.25 0.30 0.32 0.32 0.30 0.28 0.250.02 0.07 0.12 0.17 0.22 0.25 0.26 0.270.01 0.02 0.05 0.09 0.12 0.16 0.190.00 0.01 0.02 0.04 0.06 0.090.00 0.00 0.01 0.02 0.030.00 0.00 0.00 0.010.00 0.00 0.000.00 0.000.00PROBABILITY LATTICEEvolution of probabilities every year through 2020.Upstate probability = 0.71Downstate probability = 0.29Used to model evolution of demand.Assumed growth* = 18.62 %Volatility = 44.12 %Start value = 3.0 100 million kWh* Based on annual localized incremental demand growth“Call” Option in Natural Gas Plant Value of Option:- Decision analysiscompared to single large plant:$98.88m - $60.20m = $38.68m- Binomial lattice valuationProbability DemandStrategy0.18 70.94 EXPAND0.37 31.11 EXPAND0.30 15.76 EXPAND0.12 10.14 NO CHANGE0.02 8.28 NO CHANGE0.00 7.81 NO CHANGEOptimal Decision in Fifth YearBase case (500 MW) – $ 144.49mFlex case, not expand – $ 128.52mFlex case, forced expand – $ 146.42mFlex case, with option – $ 205.97m“Put” Option on Coal PlantValue of option to close = $ 3.45mValue of option to close – dynamic programming.NPV with no flexibility = $ 520.41mNPV with flexibility = $ 523.86mDecision strategy2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020523.86 715.32 898.34 1033.62 1051.08 916.39 737.77 617.36