Models for spread option pricing in energy markets

Abstract

The European energy landscape is undergoing a significant transformation, driven by the increasing importance of electrical interconnections. Interconnectors, which are high-voltage cables linking neighboring electricity systems, facilitate efficient power exchange across regions, balancing supply and demand while leveraging renewable resources. They help harmonize energy prices, promoting economic welfare, but technical constraints can lead to congestion and price disparities, resulting in inefficiencies. To manage price fluctuations arising from these challenges, financial derivatives, particularly spread options, are employed. This work discusses two models for pricing spread options based on the interconnected electricity markets of Spain and France. The first model utilizes Margrabe’s formula, while the second is designed to model the spread between power spot prices through mean-reverting processes. Subsequently, option prices are computed based on the prices generated from this spread model. A new approach refines this second model by incorporating the price difference between power futures as an input. Additionally, a trading strategy based on this new approach is developed, aiming to capitalize on auction pricing inefficiencies. The findings indicate that, despite the inherent risks involved in trading transmission rights due to the volatility and uncertainty in the electricity market, the model’s results still provide valuable insights that assist traders in making informed bidding decisions during auctions for these rights.