Abstract
We address the problem of valuing electricity generation capacity and the opportunities to invest in power generation assets in the deregulated electric power industry. The spark spread option‐based valuation framework is extended to take into consideration the electricity price spikes. This framework provides a valuable tool for merchant power plant owners to perform hedging and risk management. With jumps in the value process of power generation capacity, we demonstrate how to determine the value of an opportunity to invest in acquiring the generation capacity and the threshold value above which a firm should invest. We illustrate the implications of price spikes on the value of electricity generating capacity and the investment timing decisions on when to invest in such capacity.
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