Pricing Energy Derivatives by Linear Programming: Tolling Agreement Contracts

Valeriy Ryabchenko, Stan Uryasev

Abstract

ABSTRACT

We introduce a new approach for pricing energy derivatives known as tolling agreement contracts. The pricing problem is reduced to a linear program.We prove that the optimal operating strategy for a power plant can be expressed through optimal exercise boundaries (similar to the exercise boundaries for American options). We find the boundaries as a byproduct of the pricing algorithm. The suggested approach can incorporate various real-world power plant operational constraints.We demonstrate computational efficiency of the algorithm by pricing one-year and ten-year tolling agreement contracts.