Hedging Strategy and Electricity Contract Engineering - IFOR

72 Risk management
with the energy markets in the sense that marginal production costs and hence
electricity prices depend on the fuel prices. The marginal production cost and
hence electricity price S e in a thermal plant is essentially given by the price of
the input fuel S f multiplied with the efficiency of the plant, expressed as the
heat rate H 16 S e H S f G (3.9)
where it is assumed that the fuel costs are the only cost contributing to the
marginal cost, that electricity is priced at its marginal production cost and that
thermal plants are dominating the market and hence determining the price. A
basic electricity forward curve can via (3.9) be derived from the fuel forward
curve, which in itself can be derived from a cash-and-carry strategy, such as in
(3.8). By assuming a constant value of the heat rate the shape of the electricity
forward curve should resemble the forward curve of the input fuel. For more
information on electricity fuel arbitrage, see [Leo97].
The assumptions made are however fairly strict and from Chapter 2.3 it is
known that the fuel used will depend on the demand in the sense that for a
low demand plants using cheap fuels, such as nuclear plants will be dispatched,
whereas for a high demand expensive fuels, like gas will have to be used. The
electricity forward curve should hence depend on demand and the supply stack
and their evolution over time.
3.7.3.3. Pure electricity arbitrage approaches
The commodity based pricing approach fails to capture the specific characteristics
of the electricity prices, such as jumps. The fuel arbitrage pricing approach,
so far, does not capture the fact that the efficiency and fuel costs depend on the
demand, why the jumps stemming from dispatching a new plant technology
cannot be incorporated. To take these more realistic, but hence more complicated
price processes, such as (2.5) into account, a different approach is needed.
The price of a derivative can be derived by using the arbitrage free relationship
(3.6). Because of the complex spot price process, typically no analytical price
16 Heat rate is given by the number of units of fuel needed to produce one unit of electricity.
In Chapter 4 the conversion process of fuel into electricity will be investigated further.