Modelling price dynamics through fundamental relationships in electricity and other energy markets

Thesis

Energy markets feature a wide range of unusual price behaviour along with a complicated dependence structure between electricity, natural gas, coal and carbon, as well as other variables. We approach this broad modelling challenge by firstly developing a structural framework to modelling spot electricity prices, through an analysis of the underlying supply and demand factors which drive power prices, and the relationship between them. We propose a stochastic model for fuel prices, power demand and generation capacity availability, as well as a parametric form for the bid stack function which maps these price drivers to the spot electricity price. Based on the intuition of cost-related bids from generators, the model describes mathematically how different fuel prices drive different portions of the bid stack (i.e., the merit order) and hence influence power prices at varying levels of demand. Using actual bid data, we find high correlations between the movements of bids and the corresponding fuel prices (coal and gas). We fit the model to the PJM and New England markets in the US, and assess the performance of the model, in terms of capturing key properties of simulated price trajectories, as well as comparing the model’s forward prices with observed data. We then discuss various mathematical techniques (explicit solutions, approximations, simulations and other numerical techniques) for calibrating to observed fuel and electricity forward curves, as well as for pricing of various single and multi-commodity options. The model reveals that natural gas prices are historically the primary driver of power prices over long horizons in both markets, with shorter term dynamics driven also by fluctuations in demand and reserve margin. However, the framework developed in this thesis is very flexible and able to adapt to different markets or changing conditions, as well as capturing automatically the possibility of changes in the merit order of fuels. In particular, it allows us to begin to understand price movements in the recently-formed carbon emissions markets, which add a new level of complexity to energy price modelling. Thus, the bid stack model can be viewed as more than just an original and elegant new approach to spot electricity prices, but also a convenient and intuitive tool for understanding risks and pricing contracts in the global energy markets, an important, rapidly-growing and fascinating area of research.

Authors: Coulon, M

• Publication date: 2009
• Type of award: DPhil
• Level of award: Doctoral
• Awarding institution: Oxford University, UK
• Language: English
• Keywords: stochastic; fundamental; multi-commodity; bid stack; electricity prices; PJM; carbon market; natural gas; structural; option pricing
• Subjects: Financial economics; Mathematical finance