Pilipovic`s new real options theory: Why utilities should now value physical assets as financial options
Roxane Richter
Energy Marketing Editor
When you think of pioneering energy risk analysts, a finite set of names spring to mind. In the realm of energy derivative markets and electricity, one of the foremost names in the industry continues to be Dragana Pilipovic, the founder and CEO/CFO of SAVA Risk Management Corp. (www.sava.com). In every sense a true “rocket scientist,” Pilipovic began her career as an experimental physicist, moving into work as both a quantitative financial analyst and an energy trader. Her book “Energy Risk: Valuing and Managing Energy Derivatives” published in 1997 is considered by many as a leading edge work in the industry`s risk market.
Pilipovic recently took time out of her busy schedule of lecturing and teaching to explain her new take on the “Real Options” theory-an asset valuation methodology that re-examines the financial valuation of the utility`s full portfolio. This new and groundbreaking theory addresses the age-old question of how to include physical risk exposure into the same risk management book as contracts, including retail and non-standard contracts.
EL&P: Ms. Pilipovic, Please explain the catalyst(s) behind your asset valuation theory. What makes it particularly relevant to the industry now?
Pilipovic: There are three reasons that make the real options theory important to the utility industry now. First, overall portfolio valuation needs to include the real options theory by taking into account not only the current trading books but also current physical assets and retail positions. The second reason is the forthcoming FASB 133 accounting standards. This could be a real hornet`s nest for utilities, which now will be required to make a strict delineation between a hedge and a speculative position. So now you`ll have to show and prove that a position is a hedge, for instance. And generally this means including all assets in your risk management process. Thirdly, proper asset management. In other words, “Do I build or purchase a power plant, or do I buy a financial option instead?” You need to understand the marked-to-market value of a plant versus the costs of purchasing contracts in order to know what`s a better deal for you. Asset management is just good `new business.`
EL&P: What problem(s) does this new real option, or asset valuation, solve? Are there any consequences to not following this valuation method?
Pilipovic: I`ve been a consultant at several utilities where the top management couldn`t sleep at night. They looked at risk management and asset valuation as separate parts of the company. Well, they shouldn`t be sleeping at night, really, if they don`t understand overall portfolio valuation. Even though top management may not understand what a delta is, they do need to understand risk management and how to value their overall portfolio.
The danger of not including assets in your risk portfolio is that you that end up with a portfolio of risk management policies and procedures that don`t include your biggest position-your plants. In fact, the plants hold the biggest market price risk, or to put it another way, the risk of the change in the value of your book from Day 1 to Day 2. So how can you benchmark a reasonable hedge position if you don`t understand the other side? And portfolio optimization also needs to be considered. In order to define the optimal generation capacity, you do need to take market prices into account.
