Deregulation of electricity markets is spreading worldwide at a high speed : it has been completed for some years in Scandinavia and the United Kingdom, is well under way in the United States and being embraced in most continental Western Europe outside France. Germany and the Netherlands are quite deregulated, followed by Spain. Italy is establishing power trading in a competitive environment. This represents a multi-billion spot market that is developing very quickly. And the same pattern of evolution as in the financial markets is being observed, with the growth of a variety of derivative instruments such as forward and Futures contracts swaps, plain-vanilla and exotic options.
The main problem associated with the pricing of those derivatives is that the fundamental financial models were established for stocks and bonds and do not capture the unique features of electricity, in particular the non-storability (except for hydroelectricity), the seasonality and spikes of prices, the difficulties of transportation, (existence of high voltage lines, constraints at the hubs imposed by the Kirchoff laws), not to mention the necessity for the European Community to define clear rules for cross-border electricity transmission.
The goal of this paper is to discuss the main features of electricity spot prices and investigate the pricing issues attached to power options.