Spot Price Modeling and the Valuation of Electricity Forward Contracts: The Role of Demand and Capacity

Journal of Banking and Finance 32, Issue 12, (2008), pp. 2502-2519

55 Pages Posted: 25 Oct 2007 Last revised: 11 Mar 2013

See all articles by Álvaro Cartea

Álvaro Cartea

University of Oxford; University of Oxford - Oxford-Man Institute of Quantitative Finance

Pablo Villaplana

Comisión Nacional de Energía

Date Written: December 16, 2007

Abstract

We propose a model where wholesale electricity prices are explained by two state variables: demand and capacity. We derive analytical expressions to price forward contracts and to calculate the forward premium. We apply our model to the PJM, England and Wales, and Nord Pool markets. Our empirical findings indicate that volatility of demand is seasonal and that the market price of demand risk is also seasonal and positive, both of which exert an upward (seasonal) pressure on the price of forward contracts. We assume that both volatility of capacity and the market price of capacity risk are constant and find that, depending on the market and period under study, it could either exert an upward or downward pressure on forward prices. In all markets we find that the forward premium exhibits a seasonal pattern. During the months of high volatility of demand, forward contracts trade at a premium. During months of low volatility of demand, forwards can either trade at a relatively small premium or, even in some cases, at a discount, i.e. they exhibit a negative forward premium.

Keywords: power prices, demand, capacity, forward premium, forward bias, market price of capacity risk, market price of demand risk, PJM, England and Wales, Nord Pool

JEL Classification: C5, G00, G12, G13, Q4, Q41

Suggested Citation

Cartea, Álvaro and Villaplana, Pablo, Spot Price Modeling and the Valuation of Electricity Forward Contracts: The Role of Demand and Capacity (December 16, 2007). Journal of Banking and Finance 32, Issue 12, (2008), pp. 2502-2519, Available at SSRN: https://ssrn.com/abstract=1024243 or http://dx.doi.org/10.2139/ssrn.1024243

Álvaro Cartea (Contact Author)

University of Oxford ( email )

Mansfield Road
Oxford, Oxfordshire OX1 4AU
United Kingdom

University of Oxford - Oxford-Man Institute of Quantitative Finance ( email )

Eagle House
Walton Well Road
Oxford, Oxfordshire OX2 6ED
United Kingdom

Pablo Villaplana

Comisión Nacional de Energía ( email )

Alcalá, 47
Madrid, Madrid 28014
Spain

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