Estimating the Volatility of Spot Prices in Restructured Electricity Markets and the Implications for Option Values

The contingent claims valuation of physical assets and financial derivatives depends critically on the specification and estimation of the stochastic process that describes the price path. Accurate valuation of claims based on competitive electricity prices has proved problematic, as electricity price data are not well represented by traditional commodity price models of Brownian motion. Observed on-peak (high demand period) electricity spot prices are highly volatile and strongly mean reverting, infrequently punctuated by large upward jumps which quickly drop toward the mean price level. Existing commodity price characterizations do not capture this dynamic, though they are often used as there is no established alternative. Based on these stylized facts, continuous time models for real options and financial derivatives where the underlying state variable is the spot price of electricity have been proposed (Ethier 1997, 1999, Barz and Johnson 1998, Deng 1998). To date, these models have not been fit to market data, nor has econometric testing been undertaken.