Seminar with john e. parsons (mit), a dynamic model for risk pricing in generation investments

Abstract

Presentation
The past number of years has seen significant interest in the role of risk in the valuation of electricity generating technologies. Companies are keenly aware that different projects contain different levels of risk, that project risk may vary throughout the project life-cycle, and that the contract terms negotiated for a specific project shift the risk dramatically. Policy makers, too, have looked to shape the risk of certain investments in order to steer the profile of new generation towards low carbon sources. Unfortunately, this heightened interest has not been matched with adequate tools for properly evaluating different risk profiles. One approach leans on the now widespread availability of computing to generate large Monte Carlo distributions of payoffs to different assets or for the same asset financed with different contract. Usually the different distributions are compared on the basis of means and variances. Unfortunately, this approach ignores the key insight of asset pricing, which is that expected return is not a function of total variance, but rather of the component of variance that is correlated to macroeconomic variables. This literature is disconnected from the modern asset pricing literature. The proposed model resolves this weakness, showing how to incorporate standard risk pricing tools in order to evaluate different electricity generating technologies or different market and contracting structures. These standard risk pricing tools are known by various terminology: the stochastic discount factor, contingent claims analysis, real option valuation, and so on. When risk profiles satisfy certain simple assumptions, the tools reduce to the familiar discounted cash flow using a risk-adjusted discount rate derived from the CAPM. But the tools are flexible and also work when these assumptions do not apply. Unfortunately, for various reasons these tools are not yet widely employed by financial and policy analysts working in the power industry. This paper is intended to help remedy that.
Professor John E. Parsons, MIT, is a financial economist specializing in risk management, corporate finance and valuation. His current research focuses on the problems of risk in emissions markets—including the design of a US carbon market—risk in oil, natural gas and wholesale electricity markets, the role of trading operations in an energy company, and the valuation and financing of investments in energy markets. At MIT’s Sloan School, he teaches the finance elective Advanced Corporate Risk Management. He is also the Executive director of MIT’s highly regarded Centre on Energy and Environment Policy Research (CEEPR).