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Valuation of energy storage: an optimal switching approach

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  • Rene Carmona
  • Michael Ludkovski
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    Abstract

    We consider the valuation of energy storage facilities within the framework of stochastic control. Our two main examples are natural gas dome storage and hydroelectric pumped storage. Focusing on the timing flexibility aspect of the problem we construct an optimal switching model with inventory. Thus, the manager has a constrained compound American option on the inter-temporal spread of the commodity prices. Extending the methodology from Carmona and Ludkovski [Appl. Math. Finance, 2008], we then construct a robust numerical scheme based on Monte Carlo regressions. Our simulation method can handle a generic Markovian price model and easily incorporates many operational features and constraints. To overcome the main challenge of the path-dependent storage levels, two numerical approaches are proposed. The resulting scheme is compared with the traditional quasi-variational framework and illustrated with several concrete examples. We also consider related problems of interest, such as supply guarantees and mines management.

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    Bibliographic Info

    Article provided by Taylor & Francis Journals in its journal Quantitative Finance.

    Volume (Year): 10 (2010)
    Issue (Month): 4 ()
    Pages: 359-374

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    Handle: RePEc:taf:quantf:v:10:y:2010:i:4:p:359-374

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    Related research

    Keywords: Continuous time finance; American style derivative securities; Commodity markets; Control of stochastic systems;

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    Cited by:
    1. Álvaro Cartea & Carlos González-Pedraz, 2010. "How much should we pay for interconnecting electricity markets? A real options approach," Business Economics Working Papers wb103206, Universidad Carlos III, Departamento de Economía de la Empresa.
    2. Felix, Bastian Joachim & Weber, Christoph, 2012. "Gas storage valuation applying numerically constructed recombining trees," European Journal of Operational Research, Elsevier, vol. 216(1), pages 178-187.
    3. Bastian Felix, 2012. "Gas Storage Valuation: A Comparative Simulation Study," EWL Working Papers 1201, University of Duisburg-Essen, Chair for Management Science and Energy Economics, revised Apr 2014.

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