Ebook A spot market model for pricing derivatives in electricity markets
Contracts between electric utilities typically offer a substantial amount of flexibility in the form of complex embedded options. Demand for such optionalities arises naturally from the unpredictability of power consumption and from the optionalities inherent in power plants. In the past, there rarely was the necessity to precisely evaluate the value of these optional parts, because electricity was not a commodity which could easily be traded, and because supply of electric power was assured by utility companies under regulatory control. In fact, most counterparts did not use the flexibility of the delivery contracts in a market-orientated way. In recent years, these matters have changed dramatically. In many countries electric power markets have been liberalized and exchanges and online trading platforms for electricity contracts have been founded. Market participants now take advantage of the optionality in their contracts by optimizing against market prices and looking for arbitrage opportunities. Therefore, it has become an important task for utilities to develop new pricing models for the contracts they buy and sell and to quantify and manage the involved risks.
As an example, assume that an electric utility needs additional power at times of high demand for the first 6 months of a year. Since the utility does not know exactly when the load will be high (as it depends on uncertain factors, such as weather conditions), it signs an optional contract. One possibility is, that the utility simply buys a portfolio of call options giving the right, but not the obligation, to buy electricity each hour within the delivery period with a capacity of up to 100 MW at a fixed price of 30 EUR/MWh. This option can be viewed as a cap on an hourly power price. Another, less expensive, possibility is the purchase of a swing option. This is a contract with delivery of a certain amount of commodity on dates in the future at a stipulated constant price. The delivery dates can be nominated at short notice by the buyer within a given delivery period. In our example we assume that the utility buys a swing option, which gives the right and the obligation, to buy electricity with a maximum capacity of 100 MW, and an energy amount of 100 GWh at a fixed price, whereby the delivery may be spread over the contract period of the first half of one year. For swing options the fixed price is often specified in a way that no up front fee for the option is necessary.
To determine the fair premium for the hourly cap in the first example, or the fair fixed price for the swing option in the second example, it is necessary to analyze the traded products in the electricity markets. Commonly traded products in the electric power markets are baseload, peakload and hourly contracts. Baseload means supply with a constant capacity during the delivery period. Peakload means supply with a constant capacity during those fixed hours of a week when load usually is high. At the European Energy Exchange (EEX) for example the delivery times for peakload are defined as weekdays between 8.00 a.m. and 8.00 p.m. In the futures market contracts on both baseload and peakload are traded. The usual delivery periods are one month, one quarter and one year. In the spot market of the EEX baseload, peakload and hourly contracts up to the next weekday are traded. The underlying of the swing option and the hourly cap in our example is the hourly spot market price.
To understand the behavior of electricity prices, we have to note that electricity is scarcely storable. In most countries there are only a few reservoir power plants, and using pumps results in a loss of approximately 30% of the energy. The consequences of this non-storability can hardly be overestimated. One implication is that the relation between spot prices and futures prices cannot be described with cost of carry. The most evident result however are the enormous price fluctuations that can be observed in all electricity markets.
As shown in figure 1, those price fluctuations have a strong daily, weekly and yearly periodicity. This can be explained from a microeconomic viewpoint by looking at the market price of electricity as an equilibrium price based on supply and demand curves. Since the demand is very inelastic, the marginal costs of the supply side (described in the so called merit order curve) determine the price to a large extend. If the total load is low, the plants with the lowest variable production costs are used, if the total load is high, gas or oil fired plants with high fuel costs are additionally running. The periodicity of the total load is responsible for the periodicity of the electricity prices.
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