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Electricity price modeling and asset valuation: a multi-fuel structural approach

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  • Rene Carmona
  • Michael Coulon
  • Daniel Schwarz
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    Abstract

    We introduce a new and highly tractable structural model for spot and derivative prices in electricity markets. Using a stochastic model of the bid stack, we translate the demand for power and the prices of generating fuels into electricity spot prices. The stack structure allows for a range of generator efficiencies per fuel type and for the possibility of future changes in the merit order of the fuels. The derived spot price process captures important stylized facts of historical electricity prices, including both spikes and the complex dependence upon its underlying supply and demand drivers. Furthermore, under mild and commonly used assumptions on the distributions of the input factors, we obtain closed-form formulae for electricity forward contracts and for spark and dark spread options. As merit order dynamics and fuel forward prices are embedded into the model, we capture a much richer and more realistic dependence structure than can be achieved by classical reduced-form models. We illustrate these advantages by comparing with Margrabe's formula and a simple cointegration model, and highlight important implications for the valuation of power plants.

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    File URL: http://arxiv.org/pdf/1205.2299
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    Bibliographic Info

    Paper provided by arXiv.org in its series Papers with number 1205.2299.

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    Date of creation: May 2012
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    Handle: RePEc:arx:papers:1205.2299

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    Web page: http://arxiv.org/

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    1. Pirrong, Craig & Jermakyan, Martin, 2008. "The price of power: The valuation of power and weather derivatives," Journal of Banking & Finance, Elsevier, vol. 32(12), pages 2520-2529, December.
    2. M. T. Barlow, 2002. "A Diffusion Model For Electricity Prices," Mathematical Finance, Wiley Blackwell, vol. 12(4), pages 287-298.
    3. Lyle, Matthew R. & Elliott, Robert J., 2009. "A 'simple' hybrid model for power derivatives," Energy Economics, Elsevier, vol. 31(5), pages 757-767, September.
    4. Benth, Fred Espen & Koekebakker, Steen, 2008. "Stochastic modeling of financial electricity contracts," Energy Economics, Elsevier, vol. 30(3), pages 1116-1157, May.
    5. Geske, Robert, 1979. "The valuation of compound options," Journal of Financial Economics, Elsevier, vol. 7(1), pages 63-81, March.
    6. Schwartz, Eduardo S, 1997. " The Stochastic Behavior of Commodity Prices: Implications for Valuation and Hedging," Journal of Finance, American Finance Association, vol. 52(3), pages 923-73, July.
    7. Cartea, Álvaro & Villaplana, Pablo, 2008. "Spot price modeling and the valuation of electricity forward contracts: The role of demand and capacity," Journal of Banking & Finance, Elsevier, vol. 32(12), pages 2502-2519, December.
    8. Alvaro Cartea & Marcelo G. Figueroa & Helyette Geman, 2008. "Modelling Electricity Prices with Forward Looking Capacity Constraints," Birkbeck Working Papers in Economics and Finance 0802, Birkbeck, Department of Economics, Mathematics & Statistics.
    9. René Aïd & Luciano Campi & Adrien Nguyen Huu & Nizar Touzi, 2009. "A Structural Risk-Neutral Model Of Electricity Prices," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 12(07), pages 925-947.
    10. Markus Burger & Bernhard Klar & Alfred Muller & Gero Schindlmayr, 2004. "A spot market model for pricing derivatives in electricity markets," Quantitative Finance, Taylor & Francis Journals, vol. 4(1), pages 109-122.
    11. Hendrik Bessembinder & Michael L. Lemmon, 2002. "Equilibrium Pricing and Optimal Hedging in Electricity Forward Markets," Journal of Finance, American Finance Association, vol. 57(3), pages 1347-1382, 06.
    12. Margrabe, William, 1978. "The Value of an Option to Exchange One Asset for Another," Journal of Finance, American Finance Association, vol. 33(1), pages 177-86, March.
    13. Ali Hortaçsu & Steven L. Puller, 2008. "Understanding strategic bidding in multi-unit auctions: a case study of the Texas electricity spot market," RAND Journal of Economics, RAND Corporation, vol. 39(1), pages 86-114.
    14. René Aid & Luciano Campi & Adrien Nguyen Huu & Nizar Touzi, 2009. "A structural risk-neutral model of electricity prices," Post-Print hal-00390690, HAL.
    15. Eduardo Schwartz & James E. Smith, 2000. "Short-Term Variations and Long-Term Dynamics in Commodity Prices," Management Science, INFORMS, vol. 46(7), pages 893-911, July.
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