How Much Should We Pay for Interconnecting Electricity Markets? A Real Options Approach

Energy Economics, Vol. 34, No. 1, pp. 14–30, January 2012

36 Pages Posted: 14 Jul 2010 Last revised: 11 Mar 2013

See all articles by Álvaro Cartea

Álvaro Cartea

University of Oxford; University of Oxford - Oxford-Man Institute of Quantitative Finance

Carlos G. Pedraz

Banco de España

Date Written: May 28, 2011

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). Finally, we provide rules of thumb to interpret the different interconnector values.

Keywords: Real options, bull call spread, interconnector, electricity prices, jumps, jump filter

JEL Classification: G13, Q41

Suggested Citation

Cartea, Álvaro and G. Pedraz, Carlos, How Much Should We Pay for Interconnecting Electricity Markets? A Real Options Approach (May 28, 2011). Energy Economics, Vol. 34, No. 1, pp. 14–30, January 2012, Available at SSRN: https://ssrn.com/abstract=1639360 or http://dx.doi.org/10.2139/ssrn.1639360

Álvaro Cartea (Contact Author)

University of Oxford ( email )

Mansfield Road
Oxford, Oxfordshire OX1 4AU
United Kingdom

University of Oxford - Oxford-Man Institute of Quantitative Finance ( email )

Eagle House
Walton Well Road
Oxford, Oxfordshire OX2 6ED
United Kingdom

Carlos G. Pedraz

Banco de España ( email )

Alcala 50
Madrid 28014
Spain

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