Electricity Derivatives

More than 30 years have passed since the first country (Chile 1981) deregulated its electricity market and quoted an electricity spot price. Nearly 20 years have passed since the first quotation of a futures contract on electricity (Scandinavian market 1993). Since then, the quantitative finance literature has followed the worldwide liberalisation of the electricity industry. Amongst the many drivers that can explain the interest in this field, three of them are worth noting in a monograph dedicated to electricity derivatives.

This chapter presents the main properties of electricity, the microstructures of the electricity market and introduces the derivatives which are specific to this market. Regarding electricity’s properties, I focus only on those that have a direct consequence on pricing and trading. The fact that electricity cannot be stored cannot be understated. In the same line, the constraints on its transport make electricity a local commodity. There is no such thing as an international homogeneous electricity market or even a regional electricity market on the scales of Europe or the United States as is the case for gas markets. There are at least as many electricity markets as there are countries in the world. It is thus not possible to enter into the details of each country’s specific electricity market. Here, I deal only with the most common features of their structure. Further, I introduce some of the most specific derivatives of electricity markets by presenting the context, objective, and constraints of the electricity utilities whether they are large or small, or whether they hold generation assets or are purely retailers.

This chapter is devoted to the modelling of the electricity spot and futures prices. Since the electricity market’s deregulation, an important and increasing number of publications are dedicated to the problem of modelling the electricity spot price. I exclude from the scope of this chapter the research activity on the forecasting of the spot prices. The chapter is limited to the models that provide the dynamic of the futures prices. Indeed, modelling the dynamic of the futures prices is the basic brick for hedging and pricing more complex products. A model should be able to provide them at a low computational cost.

In this chapter, I present the derivatives that can be considered to be particular to electricity. In this regard, the spread options described in Sect. 4.1 should be considered as the basis for more complex derivatives such as tolling contracts or swing options which were first mentioned in Sect. 2.​3. Thus, I limit this section on spread options to a presentation of their different forms and on the cases where there is a closed-form formula or an analytical approximation.

After more than 20 years, research has proposed many alternative models or evaluation methods to address the problems in electricity derivatives. Indeed, from Gaussian mean-reversion processes to the cutting edge ambit fields, it seems that no modeling framework has escaped implementation in the electricity markets. But, I want to use this opportunity to propose some guidelines for future research. I currently see four major research streams.