Forecasting long-term electric price volatility for valuation of real power options

In a competitive market wholesale electricity prices drive the value of generating assets, wholesale contracts, and retail commitments. Forward prices for power unambiguously set the current value of these assets, but as in most commodity markets these prices exhibit extreme volatility. Understanding this price volatility helps quantify the risks of market participation, but also is critical to valuing options conditional on those prices. When these volatilities are unknown due to thin forward markets and a lack of price history forecasting them accurately has great business value. This paper outlines a structural approach to estimating market volatility and demonstrates its application to valuing a real option, in this case a gas-fired peaking generating unit.