42 Pages Posted: 13 Sep 2017
Date Written: September 10, 2017
Merchant commodity and energy production assets operate in markets with volatile prices and exchange rates. Producers can choose in each period between production, production suspension, and permanent shutdown. However, plant closures cause substantial financial and hard to assess social and political costs. Thus, a pure financial assessment of shutdown costs typically underestimates the actual downside of shutting down a plant. Motivated by a major aluminum producer, we study the shutdown risk of production assets. Specifically, we assess if a plant's operating flexibility can be used to help producers reduce this risk without significant asset value loss. To this end, we propose shutdown risk-averse operating policies. Two such policies employ a variant of the popular conditional value-at-risk (RCVaR) and a new notion of forgone-utility (FORU), which intuitively avoids shutdown when the upside from using a non-shutdown decision is high. Since computing these policies exactly is intractable, we employ a least squares Monte Carlo method to approximately compute them. We also introduce a shutdown risk-averse reoptimization heuristic (RH) that is relatively easier to implement. We establish that FORU policies exhibit desirable asymptotic properties not guaranteed by RCVaR and RH policies, which bodes well for embedding shutdown risk aversion using the FORU measure. We numerically compare the preceding policies and industry practice using data from a real aluminum smelter. FORU and RH policies are comparable and outperform RCVaR policies and practice-based strategies. They reduce shutdown risk by 25% and 50%, respectively, incurring asset value losses of only 2% and 6%. Our findings suggest that unaccounted social and political costs amounting to a few percent of the risk-neutral asset value can justify significantly decreasing the shutdown scenarios of production assets. In addition, operating flexibility provides an efficient lever to achieve this shutdown risk reduction.
Suggested Citation: Suggested Citation
Trivella, Alessio and Nadarajah, Selvaprabu and Fleten, Stein-Erik and Mazieres, Denis and Pisinger, David, Managing Shutdown Risk in Merchant Commodity and Energy Production (September 10, 2017). Available at SSRN: https://ssrn.com/abstract=3034869