40 © 2001, Elsevier Science Inc., 1040-6190/01/$–see front matter PII S1040-6190(01)00237-8 The Electricity Journal What Is It Worth? Application of Real Options Theory to the Valuation of Generation Assets An analysis of two generation assets in a regional market in the Northeast demonstrates how a real options-based valuation framework uncovers and quantifies the value of efficient plant operation in the face of volatile electricity market prices. The analysis shows that a peaking gas-fired facility may be more valuable than a mid-merit coal-fired plant, even though traditional methodologies would favor the coal-fired asset given its lower marginal cost. Julia Frayer and Nazli Z. Uludere eal options are an important tool in the financial valuation of generation assets, especially peaking plant and hydroelectric generators. Traditional valuation procedures, such as discounted cash flow analysis (DCF), ignore the value of managerial flexibility. These models do not capture the value embodied in the plant opera- tor’s ability to dynamically react to changing market conditions; the real options methodology mea- sures the value inherent in such adaptability. Under a real options approach, increased uncertainty (e.g., more-volatile electricity prices) translates into a larger options-based value. Peaking power plants are one of the best examples of assets that possess this flexibility: These plants can react quickly to rising electricity prices and increased electricity demand. Similarly, peaking power plants are gener- Julia Frayer directs quantitative analysis and finance projects at London Economics International LLC, Cambridge, Massachusetts. In her role as managing consultant, she has led numerous projects on valuation of generation assets, and applied real options framework in several engagements. She has extensively modeled complex lease transactions involving network assets around the world. She is also an expert on strategic bidding and market power issues in wholesale electricity markets. Nazli Z. Uludere is a consultant with London Economics. She has worked on several valuation exercises for independent power producers and multiple projects involving application of real options methodology to generation assets, transmission rights, and dispatchable load. She holds a graduate degree in finance from Boston College. R