The valuation of power futures based on optimal dispatch

Gauthier de Maere d’Aertrycke, Yves Smeers

Abstract

ABSTRACT

The pricing of contingent claims in the wholesale power market is a controversial topic. Challenges arise because of the non-storability of electricity and the number of parameters that impact the market. We propose an equilibrium model based on the fundamentals of power generation. In a perfect competitive market, spot electricity prices are determined by the marginal cost of producing the last unit of power. Electricity can be viewed as a derivative of demand, fuel prices and carbon emission price. We extend the Pirrong–Jermakyan model to incorporate the main factors driving the marginal cost and the non-linearities of electricity prices with respect to fuel prices. As load is not a traded asset, any contingent claim on power must solve, according to the Pirrong–Jermakyan framework, a high-dimensional partial differential equation that embeds a market price of risk. By analyzing the specificity of the marginal cost in power market, the problem of evaluating power futures can be simplified to make it computationally tractable. The model is then tested on the German European Energy Exchange for “German Month Futures” with maturities of June and September 2008.