TENNESSEE VALLEY AUTHORITY: OPTION PURCHASE AGREEMENTS

Options, Futures and Derivatives

In 1994, Tennessee Valley Authority (TVA) "was considering a new proposal for meeting the uncertain energy demands of the 21st century". TVA being "the largest public power utility in the United States" was subject to oversight by Congress, which in 1992 required TVA to "complete a comprehensive Integrated Resource Planning (IRP) study". The purpose of this IRP study was to assess TVA's ability to "carry out its responsibilities for ensuring ample supply of electric power for the region at the lowest feasible cost". Two key findings from the study revealed that the Electric Power Industry going into the 21st century faced greater uncertainty than it did in the past, of which TVA was not immune to, and Secondly, TVA's "single most important objective was competitiveness". TVA was faced with finding creative options within the constraints of providing power to meet customer demand at the lowest possible price, and hence it was contemplating to start trading option contracts on electricity. TVA has taken a reference from the trading of natural gas futures trading on NYMEX. The process of natural gas usage is very much same as electricity in many ways. In both the case, the end-to-end system can be divided in three components: Generators or Producers, Transmission facilities or distributors and the end users. The issues to be discussed are about the feasibility of floating options contracts on Electricity. We will have a look at them one by one. The decision for taking a call or put will depend on the demand-supply gap in the market and competitors new strategies and their respective capacities. Hence there is a need to look at the different sizes of plants that are present, namely the large size and the small size. Large size plants are those that use sources like coal, nuclear, fuels, etc. and operate continuously with incremental costs of production around $10/MWh. Small size plants are those that operate only when the continuous production capacity is exceeded by the demand and their incremental costs amounted to around $70.MWh. If we consider the current average incremental cost from Exhibit 5, the value is given to be 15.44 MWh, indicating that the demand exceeds the production capacity value of 25 kMW by approximately 2.7 kMW. Also indications of shortasge in power supply are shown through exhibit 4 b that shows projected growth in demand as minimum 25 kMW to 55 kMW. This gives a suggestion that TVA will have to enter into contracts to buy power supply from other sources. The choices present are to buy a call or sell a put. While buying a call, TVA has the right to exercise and hence it can buy as much power required a an agreed price but TVA will have to pay a premium for it. While selling a put, The exercise decision is with the counter party and hence there can be forced selling of power to TVA, but TVA will also receive some premium in this case. From large plants, TVA can buy call options or short put options since the other players have large

plants, they can produce electricity at low cost and till they are below TVAs selling price, it is profitable. From small plants, TVA should buy call options since if other players also have small plants, they will be producing electricity at high cost of $70/MWh and hence, TVA can exercise its options on only required amount of power and not buy extra power. With the options considered above, TVA would be going for buying call options. This would ensure that the exercising right is with TVA so that they don't have to oblige to buy extra power, and also the objective of the company is not trading, and hence they will have to keep demand-supply management as higher priority than the income generation form selling options. Since there is no market for power present as such, the deal price for the options will have to decided by the costs of production by the both parties and the selling prices to the consumers of electricity. And hence the prices would be decided or rather negotiated between the finalized company and TVA. Also there is not liquid market for power. Cash settlement is used when the costs of delivering the asset are more than the net cost of cash settlement and buying the asset from the market. This also assumes the availability of the asset in the marketplace. As the market for power is illiquid, TVA cannot go for cash settlement for the required amount of power may not be available in the market. Also, the transmission costs of power through the already established grids will be less. Hence TVA should go for physical delivery only. For the contract, TVA will have to provide information regarding whether they are selling put options or buying call options depending on the capacity or type of plants they are dealing with. This will depend on whether the plants can provide excessive power to TVA at agreed price, and only for the amount required by TVA. Along with this, information about size of contract and the expiry or maturity date will have to be mentioned. Once the bids have been put in, TVA can look into various factors for screening of proper firms. This would definitely depend on the price that they offer along with the flexibility thay they can provide in supply of power, as the requirement for TVA is for excessive power and this would not be a stable but fluctuating value. The technological competencies and transmission capabilities will be a deciding factor while evaluation too. Along with the above factors, TVA has to consider the various risks it is exposing itself too and these can range from the expiry date of contract to the changes in price risk. Both will deter the profits of TVA if it affects on the downside and the impact would be huge. An uncertain value is the volumes being dealt with that are on the higher side and hence it would be open to volume risk factor due to the fluctuations too.

Since valuing the contracts becomes of utmost importance considering high volumes being contracted, information regarding certain parameters becomes very important. These parameters range from deviations in requirements in power from various sources that will also affect the overall demand estimation and hence will affect the decision that needs to be taken. Another factor affecting the decision is the number of firms that are coming up in the future that would increase diversification options and increase competitive landscape too. The agreed price and credibility of the counter party will also be important for TVA to consider in the valuation as shortage of power and paying extra than the worth value will hurt TVA.