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Genco, the deregulated power generation arm of an IOU, is seeking to buy a coal-fired generation plant for merchant power in the Northeast. In order to secure financing, it must cap projected fuel costs on a long-term basis. Genco is not comfortable with locking in a term price because of uncertainty due to the length of the term, and the desire to capture some benefit from favorable price moves. Genco also does not want to pay a
premium because of capital constraints.
In response to these considerations, Genco enters into a fifteen-year coal price collar with Enron on the projected volume of coal to be consumed each month.
Under this agreement, Genco is protected by a cap price of $25.00/ton. In exchange for this protection, Genco agrees to limit its downside price potential with a price floor of $24.00/ton.
During the life of the collar agreement:
- Genco continues to buy coal from its normal sources at market prices as long as prices remain within the collar.
- If market prices move above the cap established by the collar, then Genco exercises its right to buy coal from Enron at $25.00/ton. If market prices fall below the floor set by the collar, Enron exercises its right to supply Genco with coal at $24.00/ton.
- Genco has "paid" to protect a significant portion of its production by
forgoing some of its downside price potential. In exchange, Genco has received the financial and management benefits associated with limiting upside price risk.
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