A ‘simple’ hybrid model for power derivatives

Abstract

This paper presents a method for valuing power derivatives using a supply–demand approach. Our method extends work in the field by incorporating randomness into the base load portion of the supply stack function and equating it with a noisy demand process. We obtain closed form solutions for European option prices written on average spot prices considering two different supply models: a mean-reverting model and a Markov chain model. The results are extensions of the classic Black–Scholes equation. The model provides a relatively simple approach to describe the complicated price behaviour observed in electricity spot markets and also allows for computationally efficient derivatives pricing.