TY - JOUR

T1 - A structural risk-neutral model of electricity prices

AU - Aïd, René

AU - Campi, Luciano

AU - Huu, Adrien Nguyen

AU - Touzi, Nizar

N1 - Funding Information:
We are grateful to Doctors B.-C. Koo and Y. Lee for comments on the manuscript. Computations in the present work were carried out by using CRAY T3Es at SERI in Korea and at the University of Minnesota Supercomputing Institute in the US. The work by J. K. was supported in part by the Ministry of Science and Technology through Korea Astronomy Observatory grant 97-5400-000. The work by S. S. H. was supported in part by a grant from the Korea Research Foundation made in the year of 1997. The work by D. R. was supported in part by KOSEF through grant 981-0203-011-2. The work by T. W. J was supported in part by NSF grants AST-9619438 and INT-9511654 and by the University of Minnesota Supercomputing Institute.

PY - 2009/11

Y1 - 2009/11

N2 - The objective of this paper is to present a model for electricity spot prices and the corresponding forward contracts, which relies on the underlying market of fuels, thus avoiding the electricity non-storability restriction. The structural aspect of our model comes from the fact that the electricity spot prices depend on the dynamics of the electricity demand at the maturity T, and on the random available capacity of each production means. Our model explains, in a stylized fact, how the prices of different fuels together with the demand combine to produce electricity prices. This modeling methodology allows one to transfer to electricity prices the risk-neutral probabilities of the market of fuels and under the hypothesis of independence between demand and outages on one hand, and prices of fuels on the other hand, it provides a regression-type relation between electricity forward prices and forward prices of fuels. Moreover, the model produces, by nature, the well-known peaks observed on electricity market data. In our model, spikes occur when the producer has to switch from one technology to the lowest cost available one. Numerical tests performed on a very crude approximation of the French electricity market using only two fuels (gas and oil) provide an illustration of the potential interest of this model.

AB - The objective of this paper is to present a model for electricity spot prices and the corresponding forward contracts, which relies on the underlying market of fuels, thus avoiding the electricity non-storability restriction. The structural aspect of our model comes from the fact that the electricity spot prices depend on the dynamics of the electricity demand at the maturity T, and on the random available capacity of each production means. Our model explains, in a stylized fact, how the prices of different fuels together with the demand combine to produce electricity prices. This modeling methodology allows one to transfer to electricity prices the risk-neutral probabilities of the market of fuels and under the hypothesis of independence between demand and outages on one hand, and prices of fuels on the other hand, it provides a regression-type relation between electricity forward prices and forward prices of fuels. Moreover, the model produces, by nature, the well-known peaks observed on electricity market data. In our model, spikes occur when the producer has to switch from one technology to the lowest cost available one. Numerical tests performed on a very crude approximation of the French electricity market using only two fuels (gas and oil) provide an illustration of the potential interest of this model.

KW - Electricity prices

KW - Energy markets

KW - Forward contract

KW - Fuel prices

KW - No-arbitrage pricing

KW - Risk-neutral probability

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U2 - 10.1142/S021902490900552X

DO - 10.1142/S021902490900552X

M3 - Article

AN - SCOPUS:71249136444

SN - 0219-0249

VL - 12

SP - 925

EP - 947

JO - International Journal of Theoretical and Applied Finance

JF - International Journal of Theoretical and Applied Finance

IS - 7

ER -