This paper valuates generation assets within deregulated electricity
markets. A new framework for modeling electricity markets with a Markov
chain model is proposed. The Markov chain model captures the fundamental
economic forces underlying the electricity markets such as demand on
electricity and supplied online generation capacity. Based on this new
model, a real option analysis is adopted to valuate generation assets. The
Markov chain model is combined with a binomial tree to approximate the
stochastic movement of prices on both electric energy and ancillary
services, which are driven by the market forces. A detailed example is
presented. This method is shown to provide optimal operation policies and
market values of generation assets. This method also provides means to
analyze the impacts of demand growth patterns, competition strategies of
competitors, and other key economic forces.