Developers spend a great deal of time deciding how to invest in power generating assets. Typically, though, the process focuses on acquiring an individual asset—and not on assessing the impacts to the generation portfolio as a whole. The result can be an unbalanced, undiversified portfolio of power assets that is inconsistent with the desired risk profile. Worse yet, the organization may not understand the relationship between the risk and return. Energy consultants at Webb, Scott & Quinn (WS&Q) use an efficient frontier approach to portfolio assessment that solves this problem and sets the foundation for a successful power generation business.

 

Developers use a number of tried and true approaches to generating asset valuation, including discounted cash flow and option-pricing models. But some problems exist with the way energy assets are assessed. It is basic finance knowledge that there is—or at least should be—a tight relationship between the risk and return of any investment. However, the highly volatile energy markets create a great deal of confusion to asset buyers—driven by uncertain fuel prices, overall capacity and demand, regional market structures and regulatory issues such as greenhouse gas regulation.

 

The efficient frontier is a portfolio concept designed to assess risk vs. return for an investment portfolio. While the financial projections of individual assets are key to the analysis, the end result is critical to successful structuring of the portfolio as a whole. Key to the efficient frontier is that it represents the highest level of a portfolio’s return for any given level of risk. It can be applied to physical assets (power plants), as well as financial instruments (contracts)—simultaneously.

 

By using the efficient frontier, energy investors have the ability to quickly assess their existing energy portfolios. Additionally, the outputs are also readily usable by other risk analysis and risk management tools, enabling more powerful decision making on asset utilization—such as how to market a power plant’s output in the trading arm of the organization. Most of all, the efficient frontier provides the information upon which portfolio changes should be made. The information enables an energy portfolio owner to re-structure their portfolio to be efficient—producing the highest expected return for any level of risk—by buying or selling the power generation assets that comprise an ideal portfolio. The performance of a portfolio relies on how various assets perform relative to one another under varying market conditions.

 

Data is critical in efficient frontier analysis. First and foremost, a stochastic projection of the cash flow from individual assets is required. WS&Q’s GenMetric™ model provides this data by simulating the production of energy by individual plants.  Generating asset value is calculated, as is the impact on the portfolio.

 

Once an efficient portfolio point has been selected—how is it actually achieved? In short, by divesting of and investing in specific power plant assets. Based on the current energy portfolio—and the desired efficient portfolio—the organization must add assets and remove them as defined by the selected efficient point.

Jim Letzelter

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