Spark Spread Options: Linking Spot and Futures Markets for Gas and Electricity

Fortnightly Magazine - March 15 1998
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THE RAPID DEREGULATION OF THE BULK POWER MARKET has exposed utilities and power generators to the harsh reality of spot price volatility. This new reality begs the question: How can merchant generators, independent power producers and investor-owned utilities analyze their risk exposure when energy prices vary daily or even hourly?

The answer lies with spark spread options (em the link between electric power and gas prices.

The spark spread, from a generator's perspective, refers to the difference between spot market prices for electricity and natural gas, expressed in equivalent terms through the nominal heat rate of the gas-fired unit under consideration. Reconciling the spark spread concept with actual spot prices creates the "spot market heat rate," which plays a critical role in the decision of the power plant operator to dispatch individual units.

The broader question, however, is how to integrate this spot market heat rate with information from the futures markets to calculate the present value of generating resources. What is a gas-fired plant worth today, based on the chain of traded futures contracts in power and gas? For that sort of determination, we introduce a discussion of the Black-Scholes option pricing model made famous by the work of Fisher Black, Robert Merton and Myron Scholes; the latter two won last year's Nobel Prize in Economics. As we will show, the Black-Scholes model can be applied to energy markets to infer the value of power plants, but only with certain caveats.

Heat Rates, Spot Markets and Profit

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