Switch, Switch, Switch! A Regime-Switching Option-Based Model for Valuing a Tolling Agreement

Abstract

This article proposes a real options valuation of a tolling contract using a combined switching option and volatility regime switching model. In a tolling-based transaction, the toller becomes the energy manager (but not the owner) of the power plant, having the option to switch it on or off to benefit from (mitigate) the upside (downside) potential related to frequent, jumpy fluctuations of power (and gas) prices. Value creation from such flexibility in managing the spark spread risk may be better captured by expanding the static NPV of the plant via exercise of a switching (compound) option having the plant itself as an underlying two-market-based asset portfolio (electricity and gas). Results from adoption of a pentanomial lattice pricing approach show that the set of tolling fees the toller would prefer to pay to the tollee “in equilibrium” is a decreasing function in the portfolio volatility because of the higher risk being borne by the former. Though the toller is willing to fairly pay equal or less than the value created from active management of the power plant, obtaining a positive net profit, the tollee may rely on a constant flow of bullet bond-like installments, securing remuneration of equity capital invested and arrangement of a project financing for plant construction.