Hedging Strategy and Electricity Contract Engineering - IFOR

3.7 Valuation models 69
storability, the electricity market differs substantial from the traditional financial
markets. Still there are some resemblances to, in particular, the fixed income
market. Like the fixed income contracts, the electricity contracts always
have a lifetime greater than zero. Electrical energy is the time integral of the
power, why no electrical work can be carried out unless power is delivered over
a time interval. The shortest standardized power contract is the spot contract
and the shortest fixed income contract is essentially the over-night interest rate.
The pricing of fixed income products is not unique, since the price per unit
of risk has to be exogenously determined [Vas77]. Because of the jumps, the
volume uncertainty in many contracts and the transmission constraints, all electricity
derivatives cannot be replicated, why the electricity market is an incomplete
market [EG00]. The power pricing is consequently also not necessarily
unique. Both the fixed income and the power market build up their expectations
in forward curves, even though it is normally presented as a yield curve in the
bond market. Some of the pricing models that are used by the power players
hence have their roots as fixed income model. One such equilibrium model is
the HJM model [HJM92], which extended has been proposed for the electricity
market [End99]. As for all mentioned equilibrium models the assumption of
a price process driven solely by a Brownian motion, however does not fit well
with the jumps in electricity prices.
3.7.3. Valuation of contingent power claims
Since the electricity market is incomplete, the models based on absence of arbitrage
will fail to give a unique price. Even though the equilibrium models are
frequently used in the financial industry, they do not, because of their assumptions
on simple underlying price processes, give us much operational guidance
on how to price the complex electricity derivatives. Still the players in the electricity
market need to price their contracts and a wide range of pricing models
are used in the industry.
3.7.3.1. Commodity arbitrage approaches
As mentioned in Chapter 2.6, electricity is very different from traditional financial
products. The electricity market therefore started to use pricing models
developed for the commodity markets in general and for energy markets, such