Editor: Derek W. Bunn
Published: 30 Sep 2013
Pricing electricity contracts is technically challenging, but it is a task of increasing importance as the sophistication of power trading develops. Power markets are becoming more and more financial in character, but they have their own idiosyncratic features that preclude the simple translation of models from asset pricing. Risk management is now more crucial and forward contracts need to match spot price characteristics, the market prices of risk and the corporate circumstances of traders. Furthermore, there is value in the electricity products themselves. However, specifying the required models is not straightforward. The four papers in this issue all address crucial aspects of this challenge...
Papers in this issue
by Nadi Serhan Aydın and Martin Rainer
by Miguel Vazquez and Julian Barquin
by Carl J. Ullrich
... In the first paper, "Predicting realized volatility for Nord Pool forward prices by including volatility spillover and covariance effects" by Erik Haugom, the topic of volatility prediction in financial electricity markets is extended by incorporating spillover and covariance effects. Using realized volatility and covariance, Haugom's analysis is applied to three contracts traded at Nord Pool. A robust method for separating the total variation into continuous and jump components is applied, and prediction accuracy is improved significantly when utilizing vector autoregression.
From a more fundamental perspective, Carl J. Ullrich, in his paper "Equilibrium forward risk premiums in electricity markets", develops an equilibrium electricity forward pricing model that explicitly accounts for the important consideration of constrained capacity. The model also links the forward premium to retail market conditions, since it is the balance between producer and retailer risks on each side of the wholesale market, and their consequent hedging needs, that drives the premium. The forward premium emerges as an increasing function of the ratio of the expected spot price to the retail price.
Furthermore, power markets are usually imperfect, so in our third paper, "Representing the effects of oligopolistic competition on risk-neutral prices in power markets" by Miguel Vazquez and Julian Barquin, we have a model of forward contracts that splits the power price dynamics into two different components. One component is aimed at representing costs and market power, based on a static, noncooperative game, while the other component represents short-term deviations from the static model. Synthesizing market power considerations with forward pricing is a crucial and idiosyncratic feature of electricity markets, and it is in this context that this paper makes a useful methodological contribution.
Finally, in the paper "Valuation of power swing options", by Nadi Serhan Aydın and Martin Rainer, we look at the special volume requirements that asset-based traders may bring to their trading. Bundled with electricity forward contracts, swing options address the need for some structural flexibility in both the time and volume of the contracted delivery. This paper presents an efficient numerical method to evaluate power swing options, using a state-space forest in combination with an analytic approximation of the conditional densities of the underlying processes. Again, the model is applied to Nord Pool Elspot, for the period 2008-10. An unusual extension on previous studies is that positive and negative spikes are modeled as separate mean-reverting stochastic processes. The option price characteristics are numerically represented through option value surfaces.
While it is tightly focussed on pricing power contracts, this issue of The Journal of Energy Markets should be interesting to both researchers and practitioners in energy trading. Quantitative models for electricity derivatives cannot be applied simply, and research questions remain open for substantial further work, but the work presented here could be crucial in taking both research and practice to a significant new stage.
Derek W. Bunn
London Business School
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