World Academy of Science, Engineering and Technology

International Journal of Energy and Power Engineering

Vol:9, No:1, 2015

Overview of Risk Management in Electricity

Markets Using Financial Derivatives
Aparna Viswanath

 II. OPTION THEORY

Abstract—Electricity spot prices are highly volatile under In this section, we provide a review of the various financial
optimal generation capacity scenarios due to factors such as non-
derivatives [1] that can be used for risk management.
storability of electricity, peak demand at certain periods, generator
outages, fuel uncertainty for renewable energy generators, huge A. Forward and Futures
investments and time needed for generation capacity expansion etc.
As a result market participants are exposed to price and volume risk, A forward contract is a non-standardized contract to buy or
which has led to the development of risk management practices. This sell electricity at a specified future time for a price agreed by
paper provides an overview of risk management practices by market both parties in advance. The agreed price is called the forward
participants in electricity markets using financial derivatives. price and is denoted here as FT. A futures contract is similar to
the forward contract except that it is standardized and is traded
Keywords—Financial Derivatives, Forward, Futures, Options, in the exchange.
Open Science Index, Energy and Power Engineering Vol:9, No:1, 2015 waset.org/Publication/10000205

Risk Management.
B. Call Option
I. INTRODUCTION It is a financial contract between the buyer and the seller of
the option, which offers its buyer the right, but not the
R ESTRUCTURING in electricity industry has created a
market place where electricity, just like any other
commodity, is bought and sold by market participants. The
obligation to buy a fixed quantity of the underlying at a pre-
specified strike price by the option expiration time. The seller
price and quantity trades of all the market participants is is obligated to sell the underlying if the buyer exercises the
determined by the market operator based on the supply and right to buy. The buyer of the call option pays a premium to
demand bids submitted by the generators and Load serving the seller to purchase this right. The buyer will exercise the
Entities (LSE). right when the spot price is more than the strike price and the
Spot prices are highly volatile under optimal generation payoff is the difference between spot price and strike price. If
capacity scenarios due to factors such as non-storability of the Spot price is less than the strike price then the option will
electricity, peak demand at certain periods, generator outages, expire worthless.
fuel uncertainty for renewable energy generators: e.g., wind The payoff of an electricity call option is max (ST – K, 0),
for wind generators and water for hydro power plants, huge where ST is the spot price of electricity at time T and K is the
investments and time needed for generation capacity strike price.
expansion etc. As a result, market participants are exposed to C. Put Option
price and volume risk which has led to the development of risk
It is a financial contract between the buyer and the seller of
management practices.
the option, which offers its buyer the right, but not the
This paper presents an overview of risk management
obligation to sell a fixed quantity of the underlying at a pre-
practices by market participants in electricity markets using
specified strike price by the option expiration time. The seller
financial derivatives. The paper is organized as follows. In
is obligated to purchase the underlying if the buyer exercises
Section II a review about various types of financial derivatives
the right to sell. The buyer of the put option pays a premium to
is presented. The various methods for pricing financial
the seller to purchase this right. The buyer will exercise the
derivatives are presented in Section III. An overview of the
right when the spot price is less than the strike price and the
risk management practices by market participants is described
payoff is the difference between the strike price and spot price.
in Section IV followed by conclusions in Section V.
If the strike price is less than the spot price then the option will
expire worthless.
The payoff of an electricity put option is max(K- ST, 0),
where ST is the spot price of electricity at time T and K is the
strike price.
Call and put options can be used by power market players
for mitigating their risks.

Aparna Viswanath is with the University of Newcastle, Singapore Campus,

(phone: 65-65172526; fax: 65-62732126; e-mail:
aparna.viswanath@newcastle.edu.au).

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 World Academy of Science, Engineering and Technology
International Journal of Energy and Power Engineering
Vol:9, No:1, 2015

III. PRICING OPTIONS The probability of stock price moving up can be calculated
In this section, we present a review on the pricing of options as:
using Black Scholes method [2], Binomial tree method [3] and
( rS  dS ) (7)
Monte Carlo method [4]. pS 
(uS  dS )
A. Black Scholes Method [2]
The price of option over time, under certain assumptions, Using (5), (6) and (7), it can be written as:
can be described by Black Scholes formula [2]:
f ( S )  [uS , dS , pS ] (8)
V 1 2 2  2V V (1)
  S  rS  rV  0
t 2 S 2 S The probability for reaching the j th node in the final Tth
time step is:
where S is the stock price; V is the price of the option as a
function of S; t is time (continuous variable); r is risk free probability  (
T!
). pS j .(1  pS )T  j
(9)
interest rate;  is the volatility of the stock. j !T  j  !
The market value for the European put and call option can
be derived using (1). The market value for European call The possible value of stock at j th node of the T th time step
option is expressed as: is:
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C  SN ( d1 )  Ke (  rt ) N ( d 2 ) (2) uS j .dS T  j .S (10)

The market value of the call option is the difference in the The probable value of the call option at the j th node of the
expected benefit from acquiring a stock outright and the Tth time step considering a possible strike price of KSc is
present value of paying the exercise price on the expiration
T!
day as shown in (2). Here the returns on the underlying stock ( ). pS j .(1  pS )T  j max{0, uS j .dS T  j .S  KSc}
j !T  j  !
is assumed to be normally distributed where C is call
premium; K is the option strike price; N Cumulative
j  0,1,....., T . (11)
standard normal distribution; s is standard deviation of the
The total call option considering the entire time is given as
stock.
T
T! max{0, uS j .dS T  j .S  KSc} (12)
ln(
S
K
s2
)  ( r  )t
2 (3)  j !T  j ! pS j
.(1  pS )T  j
rS
d1  j 0
s t

Binomial tree model can be used to value American options

d2  d1  s t (4) that are exercisable at any time in a given interval. The
binomial model is a discrete time approximation to the
B. Binomial Tree Method continuous process underlying the Black–Scholes model. It is
Binomial option pricing is based on the description of the computationally slower than the Black–Scholes formula.
underlying financial instrument over a period of time rather
than a single point. It uses a discrete time model. Usually the C. Monte Carlo Method
stock price is assumed to follow a Gaussian distribution. A Monte Carlo methods are a broad class of computational
binomial tree showing the changing stock price at different algorithms where the random behavior of the system is
time steps is constructed [3] as described below. simulated a large number of times, like a series of experiments
Let T be the number of steps and  S be the volatility of the and then the results are estimated. The random sampling may
be based on different probability distributions such as
stock for the specified period and rS is the (1 + interest
Exponential, Normal, Lognormal, Beta distributions, etc. [4].
rate). At each step t, the price S can move upward or Monte Carlo method is used for pricing the option based on
downward. risk neutral valuation. The technique is to generate a large
The up and down factors are calculated as: number of random prices for the underlying. The price of the
1
option value is calculated for each sample. The experiment is
S
Sup  uS  e T (5) repeated a number of times to find the average discounted
expected price of the option.
1
Monte Carlo methods are used for options with several
 S
S down  dS  e T (6) sources of uncertainty and for options with complicated
features, which would have been difficult to value using Black
Scholes model or Binomial tree model. Monte Carlo method is

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International Journal of Energy and Power Engineering
Vol:9, No:1, 2015

relatively straightforward, and allows for increasing their demand, would bid in the market for load curtailment for
complexity. Monte Carlo methods will usually be too slow monetary benefits. Increase in demand and/or generations
than the Black Scholes method or binomial tree method. shortages can result in increase in spot price of electricity.
Instead of costly spinning reserves or investing in generation
IV. RISK MANAGEMENT IN ELECTRICITY MARKET expansion, an alternative cheaper solution for the system
operator would be to pay to customers who are willing to
A. Price and Volume Risk Mitigation for Load Serving
Entities curtail their load. Customers who had the flexibility to reduce
their demand could profit when the spot price is high.
Electricity is purchased by Load serving Entities (LSEs) However, this requires the customers to consistently monitor
from the market at a price determined by the market operator the spot prices and to take risk due to price fluctuations. Risk
based on the supply and demand bids submitted by the averse customers can opt for fixed interruptible load payments
generators and LSEs respectively. LSE is obligated to supply for voluntarily reducing their consumption when the spot
electricity to retail customers at a fixed price and the required prices are high. This can be done by entering into an
quantity as demanded by retail customers. In other words, an interruptible load agreement with the market operator. In [7]-
LSE purchases electricity from the market at spot price and [11] such an interruptible load incentive is shown to be
sells it to the customers at fixed price. Therefore, LSE is equivalent to a callable forward.
exposed to price risk. Furthermore, LSE purchases fixed A callable forward is a bundle of a forward contract and a
quantity from the market and is obliged to sell whatever call option. The forward contract is purchased by the customer
quantity the customers require. The customers demand is from the utility to deliver a fixed quantity Q of electricity at a
uncertain and thus results in quantity or volumetric risks to the
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particular Time T for agreed price FT. The second part of the
LSEs [5], [6]. Profit depends on the product of price and callable forward contract is the call option, which is purchased
quantity. Small change in demand or fluctuation in price will back by the utility from the customer for quantity Q at the
lead to significant change in profits. Therefore profits of LSE strike price K. The premium for the call option is equal to the
can vary significantly due to price risks and quantity risks. interruptible rate discount.
There are many financial derivatives such as Forward, The forward contract guarantees the customer that the
Futures, Call option, Put option etc. that can be used to hedge utility will deliver Q units of electricity at time T for the
price risk but the demand is a fixed quantity. It is relatively forward price FT. The price of the forward contract is equal to
simple to hedge price risk for a fixed demand. Unfortunately, the spot price.
there are no financial derivatives that can be used directly to The call option gives the right to the utility, but not the
hedge quantity or volumetric risk. However in [6] the author obligation, to purchase back electricity from the customer at
suggests some alternative financial derivatives based on the the strike price. In the case of a call option two cases arise.
following observation. First case, if the spot price ST is greater than the strike price K,
Volumetric risks are significant to the LSE because there is the utility will exercise call option because it can buy back
strong correlation between the demand and price. This can be energy from the customer at strike price K, which is lower
explained as follows: Let us suppose an LSE purchases a than the spot price. The call option is worth (ST-K). In the
forward contract for a fixed quantity. If the demand for second case, if the spot price is less than the strike price then
electricity suddenly increases the spot price is usually very the option will expire worthless. Therefore the price of the call
high and hence the product of price and quantity is a option is max (ST – K, 0).
significant loss for the LSE. Similarly if the demand is less The bundling of the forward and the call option means that
than the forward contract the price is usually less and the the utility either delivers electricity or pays the strike price K
surplus has to be sold by the LSE below its purchase price, and interrupts the load. The price of callable forward is {ST -
again, resulting in losses. Max (ST-K, 0)} or min (ST, K).
A similar strong correlation exists between demand and
temperature. When demand is high, due to heat wave, the spot C. Options to Mitigate Exposure to Generation Inadequacy
prices will be high or vice versa. In most markets the most In this method, the peak demand of a risk averse Load
important factor affecting the price of electricity is the serving Entity (LSE) may be secured through a simple
demand. bilateral contract and the reserve margin requirements is
Due to the strong correlation between demand and obtained by purchasing a call option from the generator [12].
temperature, weather derivatives have been suggested in [6] as Call options gives the LSE a right but not the obligation to
an effective way for volumetric risk management. purchase a contracted amount of Energy, so it is more suitable
B. Modeling Interruptible Load for securing reserve capacity. The call option contracts and
bilateral contracts must be backed by generation capacity or
Utilities implemented load curtailment program, where interruptible load contracts in order to assure adequate
customers would agree to reduce their demand, in case of generation capacity. The proposed technique does not need
generation shortfall or excessive peak load demand. After any introduction of artificial products such as capacity
deregulation of power markets, the quantity measure for load payments, capacity obligations or strategic reserves
curtailment program was replaced by monetary incentives
schemes. Customers, who had the flexibility to shift or reduce

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Vol:9, No:1, 2015

procurement by system operator or operating reserve pricing The optimal amount of energy to be procured or sold by the
for ensuring adequate generation capacity [12]. wind generator and the strike prices for calls and puts is to be
The author further suggests that the LSEs can secure determined so that the profits of the wind generation company
reserves by contracting call options with high strike prices. from the call and put options with the reserve providers is
Most of the time, call options with high strike prices expire maximized for a given wind energy volatility σE and spot
worthless and so the premiums are relatively low. Further the price volatility σm. Here profit for the wind generator refers to
call options premiums for LSE can be reduced by purchasing the extra money gained through the options contracts as
spark spread (the difference between the electricity spot price opposed to the penalty and discounted price with the market
and the fuel spot price). The lower premiums for LSE are operator subject to the profit sharing agreement between the
because the price risk associated with the fuel costs is now wind generator and the reserve producer. Recall that the profit
transferred from the generator to the LSE. sharing is based on wind energy volatility and volume of
On the other hand the strike price of the call option should energy traded.
be significantly below the price cap for energy in the spot If the spot price volatility is small and wind volatility is
market. The gap between the spot price and the strike price for large (deviation from forecasted wind out is large) then as per
the undelivered energy would be the economic penalty of the the profit sharing agreement it is more profitable for the
generator for the undelivered energy. Similarly, let us assume reserve provider than the wind generator. The results of the
that a call option is purchased by the LSE from the optimization formulation shows higher Call option strike price
interruptible load. When LSE exercises its call option, and the and lower put option strike price meaning more profits for the
interruptible load is not able to curtail the load then an reserve providers.
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economic penalty is imposed on the interruptible load which is If the spot price volatility is large, the premiums for the call
the price difference between the spot price and the prevailing and put options increase thus reducing the profits of the wind
strike price. Options based generation adequacy assurances for generators.
Brazil market can be found in [13]-[15]. Black Scholes and Monte Carlo pricing based Options
hedging methods for wind power and pumped storage hydro
D.Options for Mutual Benefit of Wind Generators and
Reserve Providers units is described in [4].
In [3] a future electricity market is considered in which V. CONCLUSION
wind generators bid in the spot market like any other
conventional generators. Generators will be penalized for In restructured electricity market, financial derivatives when
underproduction and paid a discounted rate for over properly designed and implemented can help the market
production. Wind generator output depends on the wind speed participants in mitigating price and volume risk. Financial
and any deviations in the forecasted wind speed may change derivatives can be used to mitigate exposure to generation
the energy output leading to penalty or poor payment. Instead inadequacy. It can also be used to implement interruptible load
of penalty and discounted payments with the System operator, based on the market price signals thus reducing investments
call and put option based profit sharing strategy between the on costly reserves. It is an effective tool to encourage mutual
wind generators and reserve providers, which is mutually cooperation and profit sharing among market participants.
beneficial for both the parties, is proposed.
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Vol:9, No:1, 2015

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Aparna Viswanath received her PhD from Nanyang Technological

University, Singapore in 2007. She is currently working as Lecturer in
Open Science Index, Energy and Power Engineering Vol:9, No:1, 2015 waset.org/Publication/10000205

University of Newcastle, Singapore Campus. Her research interests are in

Power System planning and Power Market.

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