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

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.