Hedging Strategy and Electricity Contract Engineering - IFOR

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2.9 Price dynamic 35
To regulate unpredictable imbalances between demand and supply and to deal
with grid capacity constraints within each zone, a second physical market has
evolved, called the balance market. Active participants in the balancing market
must be consumers and producers who can respond quickly to unanticipated
power imbalances by quickly adjusting their power load or production. The
balance market can be seen as a spot market traded on a very short notice, used
by the ISO to fulfill the goal of a stable grid.
2.9. Price dynamic
According to basic economic ideas the price of a good is determined by the
intersection of demand and supply, which explicit is the pricing mechanism
that is chosen by, for example, Nord Pool. The price will therefore be directly
influenced by the supply and demand of electricity. The non-storability of
electricity produces some oddness in the spot price behavior, which creates
challenges in modeling the spot price dynamic. Here we will present the most
important features of the spot price.
In finance uncertain price processes are typically modeled in stochastic differential
equations (SDE), which are similar to partial differential equation, but
with the important extension that parts of the differential equations contains
random variables. The mother of all price models is probably the one used
in the Black & Scholes model [BS73]. In their stock model the spot price S t
follows a so-called geometric Brownian motion
dS t aS t dt F S t dW t G (2.2)
where W t is a Brownian motion. The process is called a geometric Brownian
motion because when the SDE is solved with ITO calculus 30 one sees that the
Brownian motion appears in the exponent
S t
2
2 L tMON W t P
30 For information on ITO calculus see [Øks95].