Pricing Electricity Forwards Using the Real Option Theory

Electricity Markets are liberalised in many countries throughout the world. Liberalised in the sense that the wholesale electricity prices are no longer fixed by government or a regulatory body, but rather determined by the law of supply and demand. Although the electricity market is new, the contracts traded over the counter and on exchange range from vanilla swaps to exotic options and other more complex contracts compared to capital markets. Nevertheless, there is no standard methodology for pricing such contracts as is the case of products in financial markets, where closed-form solutions of Black and Scholes type are commonly used.There has been a quite substantial research aiming to produce a benchmark pricing methodology for forward electricity contracts. To-date, there are three main schools of thought. The first one essentially applies the risk-neutral valuation approach (with some adjustment) to price electricity contracts. The second one uses simple actuarial principles based on expectation of future prices and the concept of certainty equivalent of contingent claims. The third one considers an equilibrium approach where market players are maximising the expected utility of their consumption through time, subject to constraints involving conversion of energy sources into electricity.From this perspective, the forward pricing problem based on spot electricity prices remains unsolved because the underlying asset (electricity) is not storable (economically) and cannot be traded from one period to the next. The theory of trading claims on non-tradeable assets (real options) is seen to have a natural application to electricity.In this paper, we first examine the characteristics of the electricity pool prices and look at the relationship between the spot price average and the forward price. We then apply the theory of trading claims on non-tradeable assets (real options) to electricity. The resulting forward price depends on the volume underlying the contract, the spot price weekly averages for previous periods, the market price of risk and the interest rate.In conclusion, this paper sets up a new methodology for pricing electricity forwards, where the resulting prices are more intuitive in capturing the market parameters as well as the characteristics of the underlying contract