Parametric model risk and power plant valuation

Abstract

The fact that model and parameter risk are important sources of uncertainty in option pricing models and for risk management procedures has recently been recognised for financial markets, see Cont (2006); Morini (2011); Bannör and Scherer (2013). In the context of energy markets, investment decisions are often based on the valuation of fossil power plants as real options — depending on various underlying processes such as the power-, carbon emission certificate-, and gas price. To capture parametric model risk inherent in the valuation procedure of fossil power plants, we use a methodology recently established in Bannör and Scherer (2013). As gas-fired power plants are seen as flexible and low-carbon sources of electricity, which are important building blocks in terms of the switch to a low-carbon energy generation, we consider the model risk in this asset class in detail. Our findings reveal that spike risk is by far the most important source of parametric model risk.