Spread Option Pricing in Electricity Markets
Thursday, May 17, 2012 - 11:00am - 11:45am
Spread option pricing is of utmost importance in all energy markets, and in electricity in particular due to its application to power plant valuation and risk management. However, many practitioners still rely on either complicated, intractable production cost models or convenient but overly simplified approaches like Margrabe’s formula. In addition to the highly non-Gaussian nature of log power prices, such reduced-form models fail to capture the crucial state-dependent correlation structure between electricity, fuel (coal, natural gas, etc.) and emissions prices. We propose an intuitive and tractable structural model that incorporates important but subtle effects such as merit order changes, and price feedback through emissions markets. We discuss the availability of closed-form forward and option prices in certain cases, and highlight the implications for physical asset valuation, as compared with other common approaches.