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The price of power: The valuation of power and weather derivatives

Craig Pirrong and Martin Jermakyan

Journal of Banking & Finance, 2008, vol. 32, issue 12, 2520-2529

Abstract: Pricing contingent claims on power presents numerous challenges due to (1) the unique behavior of power prices, and (2) time-dependent variations in prices. We propose and implement a model in which the spot price of power is a function of two state variables: demand (load) and fuel price. In this model, any power derivative price must satisfy a PDE with boundary conditions that reflect capacity limits and the non-linear relation between load and the spot price of power. Moreover, since power is non-storable and demand is not a traded asset, the power derivative price embeds a market price of risk. Using inverse problem techniques and power forward prices from the PJM market, we solve for this market price of risk function. During 1999-2001, the upward bias in the forward price was as large as $50/MWh for some days in July. By 2005, the largest estimated upward bias had fallen to $19/MWh. These large biases are plausibly due to the extreme right skewness of power prices; this induces left skewness in the payoff to short forward positions, and a large risk premium is required to induce traders to sell power forwards. This risk premium suggests that the power market is not fully integrated with the broader financial markets.

Keywords: Electricity; markets; Derivatives; pricing; Market; price; of; risk; Inverse; techniques (search for similar items in EconPapers)
Date: 2008
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Handle: RePEc:eee:jbfina:v:32:y:2008:i:12:p:2520-2529