The price of power: The valuation of power and weather derivatives
AbstractPricing contingent claims on power presents numerous challenges due to (1) the unique behavior of power prices, and (2) time-dependent variations in prices. We propose and implement a model in which the spot price of power is a function of two state variables: demand (load) and fuel price. In this model, any power derivative price must satisfy a PDE with boundary conditions that reflect capacity limits and the non-linear relation between load and the spot price of power. Moreover, since power is non-storable and demand is not a traded asset, the power derivative price embeds a market price of risk. Using inverse problem techniques and power forward prices from the PJM market, we solve for this market price of risk function. During 1999-2001, the upward bias in the forward price was as large as $50/MWh for some days in July. By 2005, the largest estimated upward bias had fallen to $19/MWh. These large biases are plausibly due to the extreme right skewness of power prices; this induces left skewness in the payoff to short forward positions, and a large risk premium is required to induce traders to sell power forwards. This risk premium suggests that the power market is not fully integrated with the broader financial markets.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.
Bibliographic InfoArticle provided by Elsevier in its journal Journal of Banking & Finance.
Volume (Year): 32 (2008)
Issue (Month): 12 (December)
Contact details of provider:
Web page: http://www.elsevier.com/locate/jbf
Electricity markets Derivatives pricing Market price of risk Inverse techniques;
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Hï¿½lyette Geman & Andrea Roncoroni, 2006. "Understanding the Fine Structure of Electricity Prices," The Journal of Business, University of Chicago Press, vol. 79(3), pages 1225-1262, May.
- Green, Richard J & Newbery, David M, 1992.
"Competition in the British Electricity Spot Market,"
Journal of Political Economy, University of Chicago Press,
University of Chicago Press, vol. 100(5), pages 929-53, October.
- Green, Richard & Newbery, David M G, 1991. "Competition in the British Electricity Spot Market," CEPR Discussion Papers, C.E.P.R. Discussion Papers 557, C.E.P.R. Discussion Papers.
- Ali Hortacsu & Steven L. Puller, 2005. "Understanding Strategic Bidding in Restructured Electricity Markets: A Case Study of ERCOT," NBER Working Papers 11123, National Bureau of Economic Research, Inc.
- Frank A. Wolak & Robert H. Patrick, 2001. "The Impact of Market Rules and Market Structure on the Price Determination Process in the England and Wales Electricity Market," NBER Working Papers 8248, National Bureau of Economic Research, Inc.
- Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
- Back, Kerry & Zender, Jaime F, 1993. "Auctions of Divisible Goods: On the Rationale for the Treasury Experiment," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 6(4), pages 733-64.
- Geman, HÃ©lyette & Roncoroni, AndrÃ©a, 2006. "Understanding the Fine Structure of Electricity Prices," Economics Papers from University Paris Dauphine 123456789/1433, Paris Dauphine University.
- Catherine D. Wolfram, 1999. "Measuring Duopoly Power in the British Electricity Spot Market," American Economic Review, American Economic Association, American Economic Association, vol. 89(4), pages 805-826, September.
- David M. Newbery, 1995. "Power Markets and Market Power," The Energy Journal, International Association for Energy Economics, International Association for Energy Economics, vol. 0(Number 3), pages 39-66.
- Francis A. Longstaff & Ashley W. Wang, 2004. "Electricity Forward Prices: A High-Frequency Empirical Analysis," Journal of Finance, American Finance Association, American Finance Association, vol. 59(4), pages 1877-1900, 08.
- Rudkevich, Aleksandr & Duckworth, Max, 1998. "Strategic bidding in a deregulated generation market: implications for electricity prices, asset valuation and regulatory response," The Electricity Journal, Elsevier, Elsevier, vol. 11(1), pages 73-83.
- Geman, HÃ©lyette, 2005. "Commodities and commodity derivatives : modeling and pricing for agriculturals, metals and energy," Economics Papers from University Paris Dauphine 123456789/607, Paris Dauphine University.
- Rene Carmona & Michael Coulon & Daniel Schwarz, 2012. "The Valuation of Clean Spread Options: Linking Electricity, Emissions and Fuels," Papers 1205.2302, arXiv.org.
- Cartea, Ãlvaro & GonzÃ¡lez-Pedraz, Carlos, 2012.
"How much should we pay for interconnecting electricity markets? A real options approach,"
Energy Economics, Elsevier,
Elsevier, vol. 34(1), pages 14-30.
- Ãlvaro Cartea & Carlos GonzÃ¡lez-Pedraz, 2010. "How much should we pay for interconnecting electricity markets? A real options approach," Business Economics Working Papers, Universidad Carlos III, Departamento de EconomÃa de la Empresa wb103206, Universidad Carlos III, Departamento de EconomÃa de la Empresa.
- FÃ¼ss, Roland & Mahringer, Steffen & Prokopczuk, Marcel, 2013. "Electricity Spot and Derivatives Pricing when Markets are Interconnected," Working Papers on Finance 1323, University of St. Gallen, School of Finance.
- Dorfleitner, Gregor & Wimmer, Maximilian, 2010. "The pricing of temperature futures at the Chicago Mercantile Exchange," Journal of Banking & Finance, Elsevier, Elsevier, vol. 34(6), pages 1360-1370, June.
- Furió, Dolores & Meneu, Vicente, 2010. "Expectations and forward risk premium in the Spanish deregulated power market," Energy Policy, Elsevier, vol. 38(2), pages 784-793, February.
- Caporin, Massimiliano & PreÅ›, Juliusz & Torro, Hipolit, 2012.
"Model based Monte Carlo pricing of energy and temperature Quanto options,"
Energy Economics, Elsevier,
Elsevier, vol. 34(5), pages 1700-1712.
- Caporin, Massimiliano & Pres, Juliusz & Torro, Hipolit, 2010. "Model based Monte Carlo pricing of energy and temperature quanto options," MPRA Paper 25538, University Library of Munich, Germany.
- Massimiliano Caporin & Juliusz Pres' & Hipolit Torro, 2010. "Model Based Monte Carlo Pricing of Energy and Temperature Quanto Options," "Marco Fanno" Working Papers 0123, Dipartimento di Scienze Economiche "Marco Fanno".
- Rubin, Ofir D. & Babcock, Bruce A., 2011. "A novel approach for modeling deregulated electricity markets," Energy Policy, Elsevier, vol. 39(5), pages 2711-2721, May.
- Coulon, Michael & Powell, Warren B. & Sircar, Ronnie, 2013. "A model for hedging load and price risk in the Texas electricity market," Energy Economics, Elsevier, Elsevier, vol. 40(C), pages 976-988.
- Elliott, Robert J. & Lyle, Matthew R. & Miao, Hong, 2010. "A model for energy pricing with stochastic emission costs," Energy Economics, Elsevier, Elsevier, vol. 32(4), pages 838-847, July.
- Viehmann, Johannes, 2011. "Risk premiums in the German day-ahead Electricity Market," Energy Policy, Elsevier, vol. 39(1), pages 386-394, January.
- Kanamura, Takashi, 2009. "A supply and demand based volatility model for energy prices," Energy Economics, Elsevier, Elsevier, vol. 31(5), pages 736-747, September.
- Parpas, Panos & Webster, Mort, 2014. "A stochastic multiscale model for electricity generation capacity expansion," European Journal of Operational Research, Elsevier, Elsevier, vol. 232(2), pages 359-374.
- Ullrich, Carl J., 2012. "Realized volatility and price spikes in electricity markets: The importance of observation frequency," Energy Economics, Elsevier, Elsevier, vol. 34(6), pages 1809-1818.
- Rene Carmona & Michael Coulon & Daniel Schwarz, 2012. "Electricity price modeling and asset valuation: a multi-fuel structural approach," Papers 1205.2299, arXiv.org.
- RenÃ© Aid & Luciano Campi & Nicolas LangrenÃ©, 2010. "A structural risk-neutral model for pricing and hedging power derivatives," Working Papers hal-00525800, HAL.
- Giuseppe Benedetti & Luciano Campi, 2013. "Utility indifference valuation for non-smooth payoffs with an application to power derivatives," Papers 1307.4591, arXiv.org.
- Lyle, Matthew R. & Elliott, Robert J., 2009. "A 'simple' hybrid model for power derivatives," Energy Economics, Elsevier, Elsevier, vol. 31(5), pages 757-767, September.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Zhang, Lei).
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.