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Combined Heat and Power in Commercial Buildings: Investment and Risk Analysis

Combined heat and power (CHP) systems can generate electricity locally while they recover heat to satisfy heating loads in buildings, which means they provide efficient energy. On-site generators may reduce both the expected energy costs and cost risk exposure for developers. With volatile energy prices, a deterministic modeling framework will not yield a fair value of CHP systems because flexibility in the operational response to price changes is not taken into account. In this paper, we present a Monte Carlo simulation model that is used to find the CHP value under uncertain future wholesale electricity and natural gas prices. When considering investing in a CHP system on should consider both return and risk. Clearly, both investment return and risk depend on local energy tariffs and energy loads. We highlight an example where CHP is marginally profitable and the investment decision is not straightforward. Interestingly, CHP systems were found particularly attractive with volatile electricity prices because their ability to respond to high prices provides efficient hedges to energy cost risk. Therefore, developers should not be discouraged but rather embrace on-site generation in markets with volatile prices. From the analysis, it can also be concluded that sizing of CHP systems can be related to the energy tariff structure and cost risk preferences as well as to energy loads.

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Energy Specializations: Energy Investment and Finance – Public and Private Risks, Risk Management; Electricity – Policy and Regulation

JEL Codes:
D81 - Criteria for Decision-Making under Risk and Uncertainty
E60 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook: General

Keywords: Combined heat and power (CHP), risk analysis, investment appraisal, real option valuation, Monte Carlo

DOI: 10.5547/ISSN0195-6574-EJ-Vol29-No2-7

Published in Volume 29, Number 2 of The Quarterly Journal of the IAEE's Energy Economics Education Foundation.