Publication: How much should we pay for interconnecting electricity markets? A real options approach
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2010-07
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Abstract
An interconnector is an asset that gives the owner the option to transmit electricity between two
locations. In financial terms, the value of an interconnector is the same as a strip of real options
written on the spread between power prices in two markets. We model the spread based on a:
seasonal trend, mean-reverting Gaussian process, and mean-reverting jump process. We express
the value of these real options in closed-form. We apply our valuation tool to five pairs of
European neighboring markets to value a hypothetical one-year lease of the interconnector. We
show valuations for different assumptions about the seasonal component of the spread, and
different liquidity caps which proxy for the depth of the interconnected power markets. We
derive no-arbitrage lower bounds for the value of the interconnector in terms of electricity
futures contracts. We find that, depending on the depth of the market, the jumps in the spread
can account for between 1% and 40% of the total value of the interconnector. The two markets
where an interconnector would be most (resp. least) valuable are Germany and the Netherlands
(resp. France and Germany).
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Keywords
Real options, Bull Call Spread, Interconnector, Electricity prices, Jumps, Jump filter