How Options Provided by Storage Affect Electricity Prices
28 Pages Posted: 13 Mar 2007
Date Written: February 1, 2007
Abstract
Generators supplying electricity markets are subject to volatile input and output prices and uncertain fuel availability (water flows in the case of hydro and gas availability in the case of thermal plants). We show that a price-taking generator will only generate when the output price exceeds its operational marginal cost by an amount that reflects the value of the option to delay the use of stored fuel. We argue that the option value of delaying fuel use, which is an increasing function of spot price volatility and the uncertainty about fuel availability, must be considered when evaluating whether market power is present in electricity markets. We calibrate our model to the California electricity market and show the implications of Hurricane Katrina for the offers of generators in that market. The standard approach adopted to date for simulating electricity supply curves for use in market power evaluations will produce supply curves that are quite different from those that recognize possible fuel availability limitations, even in the complete absence of market power.
Keywords: Storage, Real Options, Electricity, Market Power
JEL Classification: D4, L1, L4
Suggested Citation: Suggested Citation
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