A STRUCTURAL RISK-NEUTRAL MODEL OF ELECTRICITY PRICES

Abstract

The objective of this paper is to present a model for electricity spot prices and the corresponding forward contracts, which relies on the underlying market of fuels, thus avoiding the electricity non-storability restriction. The structural aspect of our model comes from the fact that the electricity spot prices depend on the dynamics of the electricity demand at the maturity T, and on the random available capacity of each production means. Our model explains, in a stylized fact, how the prices of different fuels together with the demand combine to produce electricity prices. This modeling methodology allows one to transfer to electricity prices the risk-neutral probabilities of the market of fuels and under the hypothesis of independence between demand and outages on one hand, and prices of fuels on the other hand, it provides a regression-type relation between electricity forward prices and forward prices of fuels. Moreover, the model produces, by nature, the well-known peaks observed on electricity market data. In our model, spikes occur when the producer has to switch from one technology to the lowest cost available one. Numerical tests performed on a very crude approximation of the French electricity market using only two fuels (gas and oil) provide an illustration of the potential interest of this model.