The "Spark Spread:" An Equilibrium Model of Cross-Commodity Price Relationships in Electricity

This paper presents a competitive rational expectations model of spot and forward prices for multiple commodities that can be stored and/or converted. As a result of the conversion option, an equilibrium theory of basis spreads across commodities is derived. This extends the "theory of storage" models to include goods which are not directly storable. In particular, we consider "upstream" (e.g., natural gas and other fuels) and "downstream" commodities (e.g., electricity). We show that many of the most intriguing empirical features of electricity prices follow naturally from the underlying economics of supply and demand. For example, the model produces mean- reverting prices, price-dependent heteroscedasticity, skewness and unstable electricity- fuel correlations. The general model can incorporate other specifications such as a commodity with multiple uses (e.g., oil and its refined products) or a single commodity at multiple locations (e.g., natural gas).