An Evaluation of Italian Electricity Generation Assets Using a Spark Spread Option Model(*)

Italy adopted the European Union Directives for the liberalisation of electricity and natural gas markets by means of two legislative decrees issued in February 1999 (electricity) and May 2000 (natural gas). Consequently, the Italian electricity monopolist Enel was obliged to sell 15,000 megawatts of its installed capacity to other operators, in order to promote competition in power generation. At the same time it was established the creation of an electricity pool that will concentrate short-term physical exchanges. In such a market, the gross operating margin – the so called Spark Spread – plays a crucial role, being the most important price signal and value driver for power generators. This paper is mainly focused on studying past and future values of the Spark Spread in Italy, showing how power generation assets can be evaluated using a Spark Spread option model. In the first paragraph we focus on the analysis of the Ct index, a sort of variable cost so far recognized to Italian electricity producers. In the second paragraph we discuss about the future organization of the electricity pool and present the principal features of existing market models which aim at replicating this system. In the third paragraph we illustrate the main features of an option-based simulation model, which allows to capture price volatility and option value of power generation assets, by using the Spark Spread concept and the theory of real options. In the last paragraph we present an application of the model to the evaluation of a merchant power plant in the Italian deregulated market and compare the results with those obtained using the traditional discounted cash flow methodology (DCF).