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How much should we pay for interconnecting electricity markets? A real options approach

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  • Cartea, Álvaro
  • González-Pedraz, Carlos

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 and express the value of these real options in closed-form. The valuation tool is applied to five pairs of European neighboring markets to value a hypothetical one-year lease of the interconnector using 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 contract and 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.

Suggested Citation

  • Cartea, Álvaro & González-Pedraz, Carlos, 2012. "How much should we pay for interconnecting electricity markets? A real options approach," Energy Economics, Elsevier, vol. 34(1), pages 14-30.
  • Handle: RePEc:eee:eneeco:v:34:y:2012:i:1:p:14-30
    DOI: 10.1016/j.eneco.2011.06.002
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    1. repec:eee:eneeco:v:67:y:2017:i:c:p:355-365 is not listed on IDEAS
    2. González-Pedraz, Carlos & Moreno, Manuel & Peña, Juan Ignacio, 2014. "Tail risk in energy portfolios," Energy Economics, Elsevier, vol. 46(C), pages 422-434.
    3. Mahringer, Steffen & Fuess, Roland & Prokopczuk, Marcel, 2015. "Electricity Market Coupling and the Pricing of Transmission Rights: An Option-based Approach," Working Papers on Finance 1512, University of St. Gallen, School of Finance.
    4. Bollino, Carlo Andrea & Ciferri, Davide & Polinori, Paolo, 2013. "Integration and Convergence in European Electricity Markets," MPRA Paper 44704, University Library of Munich, Germany.
    5. McInerney, Celine & Bunn, Derek, 2013. "Valuation anomalies for interconnector transmission rights," Energy Policy, Elsevier, vol. 55(C), pages 565-578.
    6. Ries, Jan & Gaudard, Ludovic & Romerio, Franco, 2016. "Interconnecting an isolated electricity system to the European market: The case of Malta," Utilities Policy, Elsevier, vol. 40(C), pages 1-14.
    7. Lindström, Erik & Regland, Fredrik, 2012. "Modeling extreme dependence between European electricity markets," Energy Economics, Elsevier, vol. 34(4), pages 899-904.
    8. Caldana, Ruggero & Fusai, Gianluca, 2013. "A general closed-form spread option pricing formula," Journal of Banking & Finance, Elsevier, vol. 37(12), pages 4893-4906.
    9. repec:wsi:ijtafx:v:20:y:2017:i:07:n:s0219024917500443 is not listed on IDEAS
    10. Ali Al-Aradi & Alvaro Cartea & Sebastian Jaimungal, 2018. "Technical Uncertainty in Real Options with Learning," Papers 1803.05831, arXiv.org, revised Mar 2018.
    11. Kang, Sang Baum & Létourneau, Pascal, 2016. "Investors’ reaction to the government credibility problem: A real option analysis of emission permit policy risk," Energy Economics, Elsevier, vol. 54(C), pages 96-107.
    12. Felipe Isaza Cuervo & Sergio Botero Boterob, 2014. "Aplicación de las opciones reales en la toma de decisiones en los mercados de electricidad," ESTUDIOS GERENCIALES, UNIVERSIDAD ICESI, November.

    More about this item

    Keywords

    Real options; Bull Call Spread; Interconnector; Electricity prices; Jumps; Jump filter;

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • Q41 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Energy - - - Demand and Supply; Prices

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