Optimization of Power Plant Portfolios: Impact of Cross-Border Asset Swaps, Liquidity-Constrained Trading, and Accounting Requirements

  Triangular relationship between commodity risks, cash flow restrictions and credit risks (Source: Own illustration) Triangular relationship between commodity risks, cash flow restrictions and credit risks (Source: Own illustration)

As part of the doctoral research of Joachim Lang from E.ON, FCN also investigates impacts from cross-border asset swaps, trading activity under liquidity constraints, and accounting regulation on the optimal portfolio for power generation. Currently, the following two subprojects are under way.

1. PORTFOLIO SELECTION PROBLEM UNDER RECOGNITION OF TRADING ACTIVITIES GIVEN LIQUIDITY CONSTRAINTS

The goal of this subproject is to perform a portfolio optimization analysis for a utility company with a special focus on portfolio selection problems arising from trading activities and the corresponding margining needs. Starting point is the Mean-Variance Portfolio Theory (MVP) of Markowitz (Markowitz, 1952) with regard to an underlying portfolio of power plants in Europe, and the assessment of the impact of different hedging strategies on the optimal portfolio or investment choice under liquidity constrains.

The study shall provide an instrument for the analysis of investment decisions under cash and margining restrictions for utility companies. It will be discussed to what extent the “margining aspect” must already be included in the investment decision-making process for power plants, and whether there might be differences in the fuel type dependency among the power plants under consideration. In addition, we want to explain the impact of different hedging strategies on the optimal portfolio and test it by using Monte-Carlo simulation in combination with an optimization algorithm, applying MVP.

Background of this study is the increasing relevance of selling electricity on exchanges instead of via bilateral contracts, in order to address the credit risk issue for commodity transactions. The aspect of margining is a well-known topic especially in the financial markets. However, due to the fact that most of the electricity is traded on the OTC market and that exchanges have only in recent years become sufficiently liquid for short- and long-term trading with standardized clearing procedures, this issue has been gaining importance also for the electricity sector, and has therefore also to be recognized in the optimization of power plant portfolios. One big advantage of trading energy on the electricity exchange is – besides the better transparency – also the standard procedure for the clearing of open positions. This allows to address the credit risk by having binding obligations for the payment of collaterals to a clearing company (i.e. clearing process with the usage of so-called ‘margin accounts’).

Depending on the trading positions the level of collateral might rise into billions of Euros. This binds liquidity that could be used otherwise for investments (e.g. in power plants), which is especially important as long as liquidity constrains exist. On the one side, a utility company has an interest in selling electricity and buying the necessary primary fuels on the forward markets. The motivation is “lockin” a certain margin and therefore, to accept the need of keeping an assured amount of liquidity for margining. On the other side, the company has to think about possible investment into new generation capacity in order not to lose market share or to jeopardize the sustainability of its businesses. Out of the triangular relationship of commodity price and credit risk in combination with (often externally given) cash flow restrictions arises the need for an integrated optimization of this relationship (Figure 1).

The basis for this analysis is an international power plant portfolio of the E.ON Group, which is implemented in a discounted cash flow model for calculating the net present values (i.e. the intrinsic values) of the assets. By doing so, the entire remaining lifetime of the existing generation portfolio, but also possible options of constructing new capacity, are covered. They provide the foundation for the analysis of the impact of different hedging strategies for each single asset in the portfolio and the entire portfolio. The outcome of the net present value calculations is used in combination with an algorithm to determine the efficient frontier for attractive risk-return profiles, and the change of those profiles by applying different hedging strategies.

2. IMPACT OF CROSS-BORDER ASSET SWAPS ON THE VALUATION OF POWER PLANT PORTFOLIOS

In the second subproject we elaborate the special aspects on the valuation of power plants that arise out of so-called “Asset Swaps”. To this end, we assume a utility company that wants (or is forced by regulation) to decrease its generation risk exposure in one country but is not willing to reduce its overall generation portfolio. In general there are several options, for example by selling a plant in one country and building a new plant in another country. However, this might not be the preferred solution, as building a new plant may cause significantly higher cash flow requirements in the mid-term than the company is either willing to accept or able to spend.

One possible solution to fulfil the needs of reducing the generation capacity in one country without losing market share and at the same time obeying cash flow restrictions would be an asset swap. This study therefore focuses on market-related aspects that have to be taken into account by performing asset swaps for generation units between different markets. The main question is to what extent the asset swap itself is changing the market environment (e.g. two monopolists in their respective markets are exchanging parts of their generation portfolio and are therefore forming two oligopolies) and, if yes, whether this has an impact on the valuation of the underlying assets. We will analyze the effects that occur in interrelated markets with restricted transport capacities under consideration of arbitrage aspects between the markets, in order to analyze and better understand the necessary changes for the valuation of the assets concerned.

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Reinhard Madlener

Institutsleiter FCN

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+49 241 80 49820

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