Exotic electricity options and the valuation of electricity generation and transmission assets

This 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 both spark and locational spread options for both geometric Brownian motion and mean reverting price processes. These valuation results are in turn used to construct real options based valuation formulae for generation and transmission assets. Finally, the valuation formula derived for generation assets is used to value a sample of Ph.D candidate, IE & OR Dept., University of California at Berkeley, Berkeley, CA 94720. E-mail: [email protected] Assistant Professor, EES & OR Dept., Stanford University, Stanford, CA 94305. Vice President, Risk Management, Edison Enterprises.