Spark spread options and the valuation of electricity generation assets

Abstract

The paper presents and applies a methodology for valuing electricity derivatives by constructing replicating portfolios from electricity futures and the risk free asset. Futures based replication is argued to be made necessary by the non-storable nature of electricity, which rules out the traditional spot market, storage based method of valuing commodity derivatives. Using the futures based approach, valuation formulae are derived for spark spread options for both geometric Brownian motion and mean reverting price processes. The valuation result is in turn used to construct real options based valuation formula for generation assets. Finally, the valuation formula derived for generation assets is used to value a sample of assets that have been recently sold, and the theoretical values calculated are compared to the observed sales prices of the assets.

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