RISK MANAGEMENT AND VALUATION OF ELECTRICITY DERIVATIVES

Risk Management and Valuation of Electricity Derivatives

ABSTRACT

Electricity spot prices in the emerging electricity markets are volatile, a consequence of the unique physical attributes of electricity production and distribution. Uncontrolled exposure to market price risks can lead to devastating consequences for market participants in the restructured electricity industry. Lessons learned from the financial markets suggest that financial derivatives, when well understood and properly utilized, are beneficial to the sharing and controlling of undesired risks through properly structured hedging strategies. We review different types of electricity financial instruments and the general methodology for utilizing and pricing such instruments. In particular, we highlight the roles of these electricity derivatives in mitigating market risks and structuring hedging strategies for generators, load serving entities, and electricity marketers in various risk management applications. Finally, we conclude by pointing out the existing challenges in current electricity markets for increasing the breadth, liquidity and use of electricity derivatives for achieving economic efficiency.

Table of Content

ABSTRACTII

CHAPTER 01: INTRODUCTION1

CHAPTER 02: THE ELECTRICITY MARKET4

ELECTRICITY FORWARDS, FUTURES AND SWAPS7

Electricity Forwards7

Electricity Futures9

Electricity Swap10

Electricity Options11

CHAPTER 03: RISK MANAGEMENT WITH ELECTRICITY DERIVATIVES13

Plain Call And Put Options13

Spark Spread Options14

Callable and putable forwards14

Swing options15

Pricing Electricity Derivatives16

CHAPTER 04: VALUATION OF ELECTRICITY DERIVATIVES19

A Fundamentals-Based Pricing Approach19

REFERENCES33

END NOTES35

CHAPTER 01: INTRODUCTION

Electricity spot prices are volatile due to the unique physical attributes of electricity such as non-storability, uncertain and inelastic demand and a steep supply function. Uncontrolled exposure to market price risks could lead to devastating consequences. During the summer of 1998, wholesale electricity prices in the Midwest of US surged to a stunning $7000 per MWh from the ormal price range of $30-$60 per MWh, (Woo, Karimov , Horowitz, 2004, 635)causing the defaults of two electricity marketers in the east coast. In February 2004, persistent high prices in Texas during a 3-day ice storm led to the bankruptcy of a retail energy provider that was exposed to spot market prices. And of course, the California electricity crisis of 2000/2001 and its devastating economic consequences are largely attributed to the fact that the major utilities were not properly hedged through long-term supply contracts. Such expensive lessons have raised the awareness of market participants to the importance and necessity of risk management practices in competitive electricity market.

With deregulation sweeping through the US electric electricity industry and a fully competitive marketplace for electricity taking shape, electric utilities and their customers accustomed to a cost-recovery pricing structure for electricity must adapt to market-based pricing. Risk management needs this transition has generated have made electricity derivatives one of the fastest growing derivatives markets, as financial institutions, utilities and other energy market participants work to provide the tools necessary to manage the price and investment risks associated with competitive markets. While many of the risk-management tools and methods now well established in other markets can be readily transferred to the electricity markets, the unique characteristics of electricity and electricity markets also present new challenges to the risk-management discipline. The most important of these are the challenges that the non-storable nature of electricity ...