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
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: Suggested Citation
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