This issue of The Journal of Energy Markets has a focus on option pricing. We look at both the financial options on traded energy commodities and the real options related to investment in facilities. We have two important papers on each.
In “Semianalytical pricing and hedging of fixed and indexed energy swing contracts” by Benjamin Berger, Martin Dietrich, Rainer Döttling, Pascal Heider and Klaus Spanderen, the authors observe that typical natural gas derivative contracts in the wholesale market contain several multifaceted flexibilities that protect buyers from fluctuations in price and demand. They look at fair market valuation as well as hedging with swing options. They also develop the ideas of the seminal 2004 article by Keppo, which used forwards and call options to decompose the flexibility in a fixed swing contract, by adding time-spread optionality, and they extend the decomposition approach to cover indexed swing contracts. In contrast with standard least- square Monte Carlo valuation techniques, which are limited by increasing memory constraints, the authors’ heuristic valuation approach allows for an arbitrary number of period volume constraints of the swing contract. Further, their approach can deal with 100% take-or-pay contracts, which are not typically covered by Keppo-like valuation methods. They provide backtested validations.
Our second paper, “Dynamic delta option strategies in Nordic electricity markets” by Antti Klemola, examines how electricity options traded in the Nasdaq OMX Commodities Europe financial market are priced compared with their corresponding futures contracts. For this purpose, the dynamic delta portfolio is constructed using quarterly options and an underlying futures contract. Given that the risk level of such a portfolio is adjusted on a daily basis, in such a manner that it matches the corresponding static futures strategy, the method can directly calculate the price difference between the dynamic delta option strategy and the static futures strategy. Seasonality in the price differences between the static and dynamic strategies is observed.
Turning to real options, in “Technical uncertainty in real options with learning”, Ali Al-Aradi, Álvaro Cartea and Sebastian Jaimungal introduce a new approach for incorporating uncertainty in the decision to invest in a commodity reserve facility. A real investment can be considered an irreversible one-off capital expenditure, after which the investor receives a stream of cashflow from extracting the commodity and selling it on the spot market. The investor is exposed to price uncertainty as well as uncertainty in the amount of available resources in reserve (also known as “technical uncertainty”). Investors do, however, learn about the reserve levels over time, and this is a key determinant in the decision to invest. To model the uncertainty surrounding the reserve levels and how the investor learns via estimates of the commodity in the reserve, the authors adopt a continuous-time Markov chain model to value the option to invest in the reserve and to investigate the value of learning prior to investment.
Finally, Sang Baum Kang, Pascal Letourneau and Steve X. Sala also apply real options in their paper: “A real option analysis on retiring existing coal-fired electricity plants in the United States”. The background to their work is that, in order to reduce carbon dioxide emissions from the electricity generation sector, the United States introduced the Clean Power Plan (CPP) in 2015; however, in 2017 the US federal government decided not to honor the United Nations’ Paris Agreement and repealed the CPP. In this paper, the authors study the conditions under which a reasonable green policy implemented at state level could encourage the early replacement of existing coal plants with new natural gas plants. Using a real option model, they find that the results critically depend on the remaining useful life of the existing coal plant. When this remaining life is short, policies do not play a significant role in the asset replacement decision. However, if the remaining useful life is approximately twenty-plus years, a state government’s green policy does play a significant role in the plant’s replacement. Because such plants were built during the “coal plant boom” period from 1965 to 1987, these findings are particularly relevant.
Overall, advancing the techniques for financial and real options analysis has important practical implications for energy markets and continues to present methodological challenges for researchers. This issue of The Journal of Energy Markets therefore provides valuable insights into both areas.
Derek W. Bunn
London Business School
This paper offers a new way to price and hedge energy swing contacts, decomposing swing contracts into tradeable products, adding time-spread optionality to Keppo’s approach.
This paper examines how electricity options traded in the Nasdaq OMX Commodities Europe financial market are priced compared with their corresponding futures contracts.
This paper introduces a new approach for incorporating uncertainty in the decision to invest in a commodity reserve.
This paper looks at the conditions under which a reasonable green policy by a US state encourages the early replacement of existing coal plants with new natural gas plants.