An Alternative Valuation of Energy Options for Atypical Markets

Energy has unique features in terms of storage, transportation and consumption, while the energy price in deregulated markets exhibits its own uncertainty, volatility, spikes and seasonality characteristics. Hedging with energy options (energy derivatives) provides one way that players in the market deal with the price uncertainty and associated risk. Common financial option pricing tools, such as modified Black–Scholes and binomial and trinomial lattices, can be used to value the options. However, in atypical markets, including those where something unforeseen happens in energy production or supply, or there are changes in economic conditions or external factors, such pricing tools may not apply. This chapter shows how energy options can be valued in such atypical markets. The approach adopts a probabilistic present worth analysis based on isolating the cash flows, with the approach’s strengths being that it is intuitive to understand, straightforward to implement and requires low mathematical sophistication. Different types of energy options are explored — plain call and put options, spark spread options and swing options, and options associated with callable and putable forwards. As background to the approach, the peculiarities of the Australian context on derivatives, trading and energy prices are given, including comment on the differences between the country’s various States on practices, sources of energy including renewables and varied climate effects.