Utilities Under Competition: An Options-Based Market Approach

Abstract

This paper is concerned with examining some of the implications of recent technological, regulatory, and legislative developments that have resulted in increased entry into traditionally regulated monopolies, such as telecommunications, gas and electricity. In this paper, we examine the role of pricing innovations in a restructured electric utility industry. In particular, we propose an options-based approach to the problem of resource allocation in an electricity industry facing increased competition. As electricity is economically non-storable and as demand and supply have a strong random component, options theory is a natural and, we argue, potentially superior approach to addressing the problem of risk in supply and demand. Section 1 provides background and motivation for the problem. Section 2 examines both existing approaches to pricing and our proposed options approach to allocating supply under conditions of uncertainty. Section 3 provides a description of the underlying options-based market model and discusses some problems of implementation. In addition, it relates our approach to that employed in England and Wales. Section 4 is by way of summary and conclusions. A Technical Appendix provides some analytical foundations for the approach.