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

We present and apply a methodology for valuing electricity derivatives by constructing replicating portfolios from electricity futures and the risk-free asset. Futures-based replication is 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 assets that have been recently sold, and the theoretical values calculated are compared to the observed sales prices of the assets. q 2001 Elsevier Science B.V. All rights reserved.