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UNIVERSITY OF SPLIT FACULTY OF ELECTRICAL ENGINEERING, MECHANICAL ENGINEERING AND NAVAL ARCHITECTURE

MASTER THESIS

MODELLING ELECTRICITY SPOT AND FUTURES PRICE

Boris Čikotić

Split, September 2014.

UNIVERSITY O F S P L I T FACULTY OF ELECTRICAL ENGINEERING, MECHANICAL ENGINEERING AND

UNIVERSITY O F S P L I T

FACULTY OF ELECTRICAL ENGINEERING,

UNIVERSITY O F S P L I T FACULTY OF ELECTRICAL ENGINEERING, MECHANICAL ENGINEERING AND NAVAL

MECHANICAL ENGINEERING AND NAVAL ARCHITECTURE

Field of study:

Electrical Engineering

Study programme:

Power systems

Programme number:

232

Academic year:

2013./2014.

Name and surname:

Boris Čikotić

Student number:

639-2012

THESIS ASSIGNMENT

Headline:

MODELLING ELECTRICITY SPOT AND FUTURES PRICE

Assignment: Describe various models, market structures and functionality of power exchanges using several exchanges in Europe as a reference. It is also necessary to describe the derivatives market and the manner of functioning of market products such as options and futures contracts. Single out one exchange in Europe and make a detailed description and conduct a basic statistical analysis of prices in last 10 years. Conduct spot price simulations using simplified stochastic processes and illustrate a basic protection against risk using futures contracts.

Application date:

Thesis submission deadline:

Thesis submission:

03. March 2014.

15. September 2014.

01. September 2014.

President

Thesis defence committee

Associate professor, Goran Petrović, Ph.D.

Mentor:

Associate professor, Ranko Goić, Ph.D.

TABLE OF CONTENTS

1. INTRODUCTION

1

2. ELECTRICITY MARKET LIBERALIZATION

2

2.1. Liberalisation process

3

2.2. Conditions for reform

10

2.3. Measures of liberalisation and deregulation

13

3. ELECTRICITY MARKETS

15

3.1.

Market Structures for electricity

16

3.1.1. Pool model

17

3.1.2. Power exchange

18

3.2. European power exchanges

23

3.3. European Energy Exchange EEX

27

3.4. Spot market

29

3.5. Derivatives market

48

3.5.1. Futures contracts

49

3.5.2. Forward contracts

57

3.5.3. Option contracts

57

4. MARKET SIMULATION MODELS

62

4.1.

Stochastic spot price modelling

63

4.1.1. Basic statistical analysis

66

4.1.2. Brownian motion

70

4.1.3. Parameter estimation

73

4.1.4. Mean reverting processes

76

4.1.5. Jump diffusion processes

82

4.2.

Derivatives modelling

84

4.2.1. Modelling futures contracts

85

4.2.2. Modelling options

90

4.2.3. Economic application of simulation models

98

5. CONCLUSION

107

REFERENCES

109

1.

INTRODUCTION

The electricity industry has undergone big structural changes over the last two decades. Traditionally, electricity companies were regulated or state-owned monopolies governing the generation, transmission, distribution and retail of electricity. In this regulated setting, power prices changed rarely and did so in a deterministic way. As a result of this restructuring, prices are now set by the fundamental powers of supply and demand.

In these new, liberalized electricity markets, national and international parties have joined the formerly exclusive group of market participants, creating new risks as well as new opportunities for utility companies, distributors and consumers alike. Electricity wholesale markets are now the centres of an increasing amount of trading activity in spot contacts (short-term delivery of electricity). Because of the large price risk involved in trading spot contracts and the wish to hedge (price) risk in general, other contingent claims such as futures, forwards and options have been introduced to the electricity market.

Thesis is split into two parts. First part, which includes the second and third chapter, lists basic steps of electricity markets liberalization process, explains various types of markets, lists the majority of European power exchanges and explains the structure of spot and derivatives market. Combining electricity trade of a large part of continental Europe, European Energy Exchange EEX was used as a referent power exchange.

Second part, which includes the fourth chapter, reviews simulation models used to model spot prices and explains models used to evaluate the price of futures contracts and option premiums. Several economic applications of simulation models are mentioned, both for business analysis and hedging. Historical prices from EEX exchange are used as a reference, specifically spot and futures prices and option premiums with delivery in Germany/Austria. During spot price simulations only stochastic processes were analysed. To simulate the movement of futures prices two distinct approaches were mentioned. One of which is a direct linking of the futures price with spot price and the other a separate and independent modelling of the futures price. Options are written on futures contracts and their premiums are determined by the characteristics and price movements of futures contracts and they were modelled using a well known Black 76 formula.

2.

ELECTRICITY MARKET LIBERALIZATION

The current reform in the global electricity supply industry (ESI) is often presented as being a sudden change. Whilst it is certainly true that there are, in any one country, step changes of rules, regulations, laws and structures, that are commonly associated with a timetable of deadlines, they are in practice part of a continuum in which major structural changes took about ten years to agree, and ten years to implement and settle down.

At high level, the reasons for reform are the growing belief, based partly on experiences to date, that by market orientation, the industry can be more efficient.

Having begun as liberalised free enterprise in the 1880’s, and fallen into municipal, federal hands over the next few decades, the liberalisation experiment began in 1970’s with a partial opening of the generation sector to new entrants from whom the utilities were required to buy, and continued in the 1980’s with the beginning of consumer choice. The 1990’s saw the beginnings of competitive electricity markets with the growth of pool models, and the year 2000 saw the first bilateral physical market with the New Electricity Trading Arrangements (NETA) in England and Wales.

Change was then rapid with the proliferation of market opening and power exchanges across the world, and development of the market models for capacity, location and environmental factors.

The journey has been broadly consistent in most countries and has been characterised by many elements, such as reform, liberalisation, deregulation, re-regulation, third party access, privatisation and unbundling. Many of these elements are now complete in many countries and at this point, the countries are considering the virtues and drawbacks of the new model, and in some places taking the market model to new levels of technical complexity.

The challenge has been to open the market to competition in a measured and controlled manner such that each stage can be viewed in retrospect with regard to intended and unintended impacts. In doing so, there is the recognition that networks have a strong tendency to being natural monopolies, and hence that liberalisation and deregulation must begin with power generation and supply.

If there is common ownership of networks and generation, or networks and supply, or both (as there is in a national monopoly), there is conflict of interest, so that the incumbent is incentivised to raise the entry barrier and excessively charge the new entrants. Hence, new

entrants need to be guaranteed free and fair access to power generation or consumption. This is by no means simple, even with the best will of the incumbents because the operation of power generation and of the transmission grid is optimised as a single entity.

Hence to allow competition, it is first necessary to restructure the national monopolies into vertically de-integrated (unbundled) form, and for there to be some form of commercial arrangement between the unbundled tiers so that this arrangement can be followed by the new entrants.

There are essentially three components to liberalisation in the ESI:

Reduction of the role of the state, in terms of ownership, command and control, prescriptive solutions and direct cross subsidy.

Creation and enhancement of competition by deregulation, vertical de-integration (unbundling), horizontal de-integration (divestment) and regulated third party access.

Increasing choice for consumers and participation in short and long term demand management and responsibility to secure their energy.

From an industry perspective, some liberalisation objectives are:

Introduce competition in generation.

Introduce customer choice.

Deal with independent power producer and stranded cost issues.

Attract private investment.

Entrench universal service obligations.

Promote integration of the grid.

Reduce debt.

2.1. Liberalisation process

We have noted that the ESI is highly complex due to the special nature of electricity and that there is a very wide variation in key factors such as energy endowment and social model. There is no ‘one size fits all’, and since no policy maker can unilaterally impose a new model and design by committee is difficult.

Therefore the ESI takes incremental steps. This is shown in Figure 2-1.

Figure 2-1. Planning small changes in a complex market [1] Most countries are undertaking liberalisation

Figure 2-1. Planning small changes in a complex market [1]

Most countries are undertaking liberalisation in some form, and the starting point, pace and scope varies in each country. There are several steps. The list below is in approximate order, but this has been different in different places.

Corporatisation.

Unbundling.

Ring fence chosen sectors. For example, nuclear, hydro, grid;

Privatisation.

Forced divestment and fragmentation of incumbent utilities.

Deregulate.

Reregulate.

Further fragmentation.

Further unbundling and opening to competition.

Re-integration of some sectors and cross sector integration.

Re-consolidation

Horizontal integration with other industries.

Entry of financial institutions into the wholesale markets.

Pressure on retail deregulation.

Further deregulation of networks and metering.

Revise model.

Unbundling is one of the foundations of ESI reform. It is the separation of the vertically integrated industry sectors in such as manner as to facilitate competitive and non discriminatory access of participants to means of operation and route to market for the products or services. At the highest level, the industry divides neatly into the four sectors:

generation, high voltage transmission, low voltage distribution and supply.

voltage transmission, low voltage distribution and supply. Figure 2-2. The unbundled ESI model, showing the four

Figure 2-2. The unbundled ESI model, showing the four main industry sectors [1]

It is clear, for example, that if a generator wishes to access the consumer market that without unbundling, a vertically integrated participant could easily deny access to the delivery of electricity.

There are different degrees of separation in the unbundling processes that should be considered as stages.

Functional separation This involves the separation of the day to day business and operation of the divisions. Whilst resources should be clearly allocated between the divisions, there is no specific requirement for the inter business arrangements to be on a commercial basis. For example, one could be a cost centre. However, the path is clearly laid open for full separation, since cost centres can optimise and prioritise effectively only if the services provided have clear monetary signals, thereby forcing the profit motive, a profit centre approach and then standalone businesses.

Operational separation This involves separation of long term decisions, capital expenditure and operation of the businesses. This is a natural progression from functional separation, and the natural separation of board level decisions makes the path for board level separation.

Accounting separation This involves the formal production of separate accounts for the different parts of the business. Whilst this requirement may at first sight appear a relatively straightforward one, involving capital expenditure, depreciation, core operating budgets and some form of financial arrangement between the respective divisions, the construction of full statutory accounts for each division actually sets a clear path for full separation of the businesses since all resources must be accounted for in one business or other, and all flows of commodity or service from one to another should be treated as ‘arms’ length’ arrangements on commercial terms. In practice, journey from informal inter business arrangements to formal commercial arrangements is a long one and hence there are many degrees of accounting separation.

Legal separation The component companies are completely separate from a legal perspective, although they could be ultimately owned, in whole or part, by the same entity.

Ownership separation This means no significant common ownership.

As a general rule, partial unbundling of generation is the first step, by allowing and encouraging private new entrants. This can be regarded as stepwise deregulation. The next major step is the separation of the high voltage grid from the other sectors. The unbundling of supply from distribution is generally a late stage, and gradual deregulation of metering, and networks at their boundaries and various support services continues after the main unbundling is complete.

Corporatisation is a necessary precursor to unbundling because the unbundled sectors cannot operate independently without being corporatized. Corporatisation is the process by which a publicly owned company with a public service franchise and purpose starts to behave like an investor owned company. This it self has many elements:

The requirement of each entity not to lose money, with no cross subsidy from one entity to another. (Pareto optimality, applied within the firm).

Migration of some long term and high level responsibilities back to governments. For example nuclear decommissioning.

Public service becoming a requirement rather than a purpose.

Preparation for unbundling by internal transfer pricing, and service level agreements.

Increased independence from the fiscal and monetary structure of the nation. For example, payment of taxes, payment for fuel.

End of requirement to create labour.

One of the first stages of corporatisation is by introducing formal arrangements between the sectors that will be unbundling. This includes payments for goods and services. The arrangement is shown in Figure 2-3. Each sector has cash inflow and goods and/or service outflow. Consider initially a centrally managed economy. This is depicted in Figure 2-4. In the extreme case for a closed economy with no money, then labour and natural resource replaces the tax required to buy equipment.

natural resource replaces the tax required to buy equipment. Figure 2-3. Formal arrangements between unbundled sectors

Figure 2-3. Formal arrangements between unbundled sectors [1]

2-3. Formal arrangements between unbundled sectors [1] Figure 2-4. Arrangement for a centrally planned economy [1]

Figure 2-4. Arrangement for a centrally planned economy [1]

Regardless of ownership, the state is the ultimate guarantor of ESI performance. Accordingly, governments have been reluctant to relinquish control in some areas. The main three areas are described below.

Nuclear power This has commonly remained under national control because it has been considered that governments should be able to determine the amount of nuclear power generation in the future, that nuclear decommissioning funds can only be assured by public sector retention, that consolidation of nuclear power maximises safety, and that overall public interest with respect to such a long term issue as nuclear power can only be served by having national ownership and accountability through the electorate.

Hydro power The case for public sector retention for existing large hydro plant for the protection of public ownership of natural resources is not particularly compelling in countries which have been happy to privatise fuel and mineral extraction. However, the construction of large dams requires such significant trade offs between national and local environment that sometimes the public interest can only be best served by public ownership. The control of hydro dispatch is also highly useful for the system operator. In addition, international aid, commercial loans and ‘soft loans’ in relation to large hydro schemes and the sheer size of the schemes often calls for a high degree of state involvement.

National grids National grids are commonly retained because it was felt, with some justification, that the grids form the focal point through which the industry is managed in the short and long term. By maintaining control of the grid, there was de facto control on every other sector, and by maintaining control of the grid, it was possible to form a coordinated view of security of supply, and then facilitation of whatever construction is required to alleviate this.

When state monopoly is corporatized, vertically unbundled and horizontally fragmented, then component parts can be privatised, one at a time, or all together.

There are essentially three types of privatisation:

Widely distributed, in which the share price is set low and there is a per capita allocation to the population.

Public offerings, in which investors (both strategic and institutional) buy the stock.

Trade sale, in which the whole organisation is sold to a single company.

The privatisation process is a very sensitive one, since the ESI is seen as a national asset and there is often a risk (perceived or actual) that the stock is sold at low prices to individuals and companies with political connections.

The regulated sector is comprised of privately owned local monopolies, but has prices, revenues and/or profits regulated by government through the regulator. Deregulation is the process by which parts of the regulated sector are opened to competition.

We have seen how the generation sector has generally been open to competition for a long time, and even when the dominant incumbent generator is regulated, generation competition is not usually classed as deregulation. Almost always, deregulation begins by a gradual opening of the supply sector to competition, starting with the very largest consumers, with a phased opening of the market to smaller and smaller consumers, and eventually residential consumers.

The deregulation process leads to the existence of two distinct sectors the deregulated sector which is open to competition, and the regulated sector which has regulated prices or revenues. Regulation is applied to both sectors, but is more of a monitoring, guiding and policing role in the deregulated sector than a price setting one. From a regulatory perspective, the retail sector is the most important sector, since this is the interface between ESI and consumer.

The presence of financial institutions should be regarded as a measure of success, of market reform. Financial institutions can enter the industry in a number of ways including strategic investment, loans, wholesale market trading and electricity supply. There have been several circumstances in which creditors have acquired the assets of power companies as collateral on default.

There are a number of measures of success for ESI reform. In the light of these we must decide: if there has been sufficient market reform to achieve success and if the market has reformed substantially, then how should we adjust the model to improve ESI performance in delivering welfare, how to deliver further economic and environmental efficiency.

There are a number of areas to examine, including::

Prices what has been the effect of reform on prices, and what can be done?

Consolidation how much is too much?

Demand management will market mechanisms eventually deliver this, or must a prescriptive solution be applied?

Data is the electricity meter flow data structure robust enough to recover from errors and to handle events such as change of supplier, occupier, or meter?

Metering to facilitate demand management, should parts of the metering sector be regulated or deregulated?

The macroeconomy how much do increasing prices resulting from environmental limitations affect the economy?

The environment taxing externalities, or command and control.

Security of Supply assignation of responsibility or mechanisms for security of supply.

Universal service.

Cross subsidy.

2.2. Conditions for reform

Early stage reform, such as corporatisation, and high level administrative unbundling, provides quite different challenges to late stage reform, such as exposing elements of transportation to competition and the development of wholesale derivative markets. To enter each stage of reform, there are prerequisites in terms of will and capability.

Generation capacity The implementation model depends greatly on the current generation capacity in relation to demand. If capacity is insufficient, then priority is fair market access rather than competition in generation. If capacity is excessive, then the divestment of ownership must provide current stability (possibly including vesting arrangements for stranded assets), both for the dominant incumbent and the new players, as well as a road map for both retirement and new build.

Investment environment This is enhanced by stability of laws and taxes, mature local financial markets, freely traded currency, absence of hyperinflation and low country risk.

Rationalised cross subsidies The cost of low consumer prices arising from industry subsidy must be recovered by taxes, either from the subsidised consumers, or other consumers. In this circumstance, new entrance is not possible, and the cross subsidy system has to gradually unravelled.

The will to disaggregate the ESI from the national economy to some degree. The ESI can be a haven for employment in both the ESI and in the fuel sector.

A high voltage grid that is sufficiently present and reliable.

The ability to collect tariffs for electricity, supported by the laws, police and courts, property access rights and disconnection rights.

Supportable universal service requirements.

Even in a fully privatised industry, the ESI is a collection of assets, existing property rights, right to build, franchises and obligations that has an inbuilt legacy relationship between private and public sectors that is de facto and informal as much as it is formal. These relationships built up incrementally as the industry developed, with a few step changes such as nationalisation and deregulation that in fact made relatively slight differences to this collection. The state therefore retains an intimate connection with the running of the ESI.

The state is the ultimate guarantor even if companies in the industry fail. In developed economies, this is particularly important in the consideration of security of supply. The state has a remit to monitor the current and likely achievement of national and international policy objectives that are affected by the ESI, and to intervene where the delivery falls short or can be enhanced.

Electrification (connection of the population to the electrical infrastructure) is seen as an essential development for welfare and economic growth. In the absence of a complete market for emissions or equivalent, the state must manage aggregate welfare by economic or prescriptive instruments.

The state performs numerous roles, for example:

The participation of the ESI in the fiscal structure of the macroeconomy.

The setting of policy.

Primary legislation (Acts of Parliament) to drive and control policy.

The conversion of direct taxes to indirect taxes

The management of those parts of the ESI that remain under state control.

Consumer subsidy if the requirement for cross subsidy within the ESI is reduced.

Corporate cross subsidy by taxation and concessions.

Prices are not the only measure of the success of liberalisation, and that prices are but one outcome of political model and industry structure. We can see in Figure 2-5. that there can be a wide variety of electricity prices, depending on the degree of state subsidy, which itself is dependent on the tax revenue (and welfare saving if unemployment is reduced) from the ESI.

Indeed either the fully managed model or the open market model can in theory achieve low prices when pursued to its logical conclusion.

achieve low prices when pursued to its logical conclusion. Figure 2-5. The role of the ESI

Figure 2-5. The role of the ESI in the fiscal structure of the macroeconomy [1]

Regardless of ownership, the government has ultimate right of control. To the industry this represents a ‘moral hazard’ as well as a potential lifeline for ailing companies as well as protection for consumers. The government is the de facto ultimate guarantor of the industry performance in terms of the delivery of electricity to consumers.

Governments can and do retain substantial influence of nationalised and other private companies. Such mechanisms include:

Shares Full or partial ownership, golden shares (a share with significant voting rights but no significant economic value).

Legislation Primary legislation (Acts of Parliament), secondary legislation (the detailed drafting of the Acts).

Taxes New taxes, windfall taxes, change in tax rates, tax breaks, categorisation of tax liability.

Licences – Generally determined by legislation, moratoria, as ‘soft’ mechanisms such as slowing down the on going series of permissions.

Rules and regulations.

Arbitrating and determining On disputes between different parties, and on interpretation of laws and regulations.

Administration Slowing the operation of the company by means of enquiry and general administration.

Retained ownership Of key sectors.

Discretionary enforcement of laws and regulations, and implicit connection between ESI implementation of one policy and enforcement of a completely separate law or regulation.

2.3. Measures of liberalisation and deregulation

Since liberalisation and deregulation is a global experiment, it is natural to wish to compare the experiences across the world. There are many comparative indicators, some of which are listed here.

Declared level of opening percentage market openness, pace of opening, import- export extent, presence of international commercial agreements.

The planned year of full market opening.

Price level of transmission network usage separate tariffs for energy and transport, within the country and with neighbouring countries.

The way the transmission network is allocated.

o

Separated by ownership from other ESI sectors.

o

Legally separated as a separate entity in which other participants in the ESI may have a part ownership.

o

Separated at the management level from other ESI sectors.

The way the market is regulated.

o

Regulated third party access, controlled by an independent regulatory body.

o

Negotiated third party access

The existence of the Balancing market.

The market share of the biggest / largest manufacturers.

European Commission Directorate General, Transport and Energy Energy liberalisation indicators in Europe (2001) This considers the regulated and deregulated sectors separately. In the deregulated sectors it considers matters such as development of competition and development of the wholesale markets. In the regulated sectors it considers matters such as access and interconnectivity of networks.

EU benchmarking studies These are published specifically in relation to the EU Directives, but are quite general in nature, and include non EU countries such as Norway. The first, second and third benchmarking reports were produced in 2001, 2003 and 2004, and

focus on matters such as liberalisation timetables, roles of regulators, market monitoring, network access and tariffs, as well as other issues such as treatment of congestion, transmission investment, interconnection, cross border tariffs and balancing services.

Centre for the advancements of energy markets (CAEM) Retail Energy Deregulation Indicator (2001) This considers specifically the retail sector. It has 22 criteria, each with a score of 1 to 100. Examples are:

Is there a detailed plan for customer choice?

How many customers can currently make a choice and how many have switched to competitive suppliers?

Are there standard business practices and is competition in metering and billing allowed?

Is generation deregulated and is there a vibrant wholesale market?

How are customers integrated into the programme? Are they informed about their options? Is customer information disseminated to promote competition? Are customers encouraged to shop in the competitive market?

Are utilities encouraged to offer new services and to cut costs for the transportation services they provide?

Has the state commission adopted internal reforms to accommodate their new responsibilities?

There are also a number of studies by consulting organisations, academic institutions and international bodies, and best practice guides.

3.

ELECTRICITY MARKETS

In economic terms, electricity is a commodity that can be bought, sold and traded. The electricity market is a system in which prices are formed from the best offers to buy or sell. Lowest offer for sale is the most favourable offer to buy (Ask price), and the highest offer to purchase is the most suitable offer to sell (Bid price). The difference between ask and bid price is called the spread in which the average price for a traded asset class is always located, as a middle ground between bid and ask. Large spreads indicate high transactions cost, low liquidity or an increased volatility. What makes electricity market different from other markets are additional characteristics and parameters related to each MWh (or MW) of electricity traded on the exchange.

The most important characteristic of electricity is that it can not be efficiently stored and it can not be stored in large quantities. Consumption and production of electricity has to be balanced at all times to avoid sudden changes in power network frequency, which would have disastrous consequences.

Electricity market requires a place and a market operator where transactions are executed, and offers to buy and sell electricity may be submitted. Market operator provides a trading platform on which a market participant may trade on the exchange, and supporting financial, human and material resources required to perform transactions on the exchange. All offers and transactions on the exchange must be submitted to brokerage firms which pass them on to the exchange. Brokers take a commission on each trade and competition arises in this segment of the business as well, making commissions consequently lower.

Electricity is primarily traded on the spot market for a defined delivery period in so called blocks of electricity. Most of the trade is done for a delivery period of one hour. Spot market trading is conducted on day-ahead auctions and intraday market. Electricity indices are using average prices from the spot market as the underlying price.

Along with spot market there is also a power derivatives market of futures contracts and options. Futures contracts are traded as a 1 MW of Power that will be delivered during a defined period of delivery in the future. Delivery periods can be from one day to one year. Options are traded as the right to buy/sell a futures contract at a given price before expiry of the option.

Currently leading power exchange in Europe EEX (European Energy Exchange) combines trade for delivery of electricity to large part of continental Europe. Market operator is a private company EEX AG. With electricity other commodities and asset classes are traded as well, such as: power derivatives, guarantees of origin, natural gas (spot and futures market), emissions allowances and coal.

3.1. Market Structures for electricity

At the beginning of electricity market liberalization, previously monopolistic model is transformed in order to achieve a wholesale market at first and later a complete power exchange market. In order to reach a wholesale model, market is usually transformed into a single buyer model, and the retention period on this simple model depends on many factors within the country where the market is transformed. Single buyer model is characterised by the fact that producers only have one buyer to whom they can sell. This model is a natural step in the liberalization process, before moving to a wholesale model.

Basic characteristics of a wholesale model can be summarized as follows:

Partially open market with a limited number of consumers, defined mostly by the size of annual consumption, while other consumers are in the public service, that is, they are supplied by one supplier provider of public service.

Manufacturers independently contract delivery method and price of electricity to eligible consumers. Small consumers are supplied by the tariff system defined and approved by an independent regulatory body.

Transition to a wholesale model requires significant transition costs and and additional costs of administration access to and use of the transmission and distribution network.

Electricity price of risk (production cost, market price) are transferred mainly to producers and consumers, as opposed to a non-market system where risk is exclusively on consumers.

In relation to monopoly system, wholesale model reduces political influence, though not entirely. The basic premise for this is certainly a well-defined legal framework and technical regulation of electricity market.

Wholesale model is always a precursor model of the open market (retail competition) in which all consumers are allowed to have a free choice of their electricity supplier.

Basic versions of the wholesale model, based on how the electricity market is organised, are bilateral model, pool model, and their various blends. In purely bilateral electricity market it is assumed that market mechanisms, based on bilateral agreements between manufacturers and trading companies, will lead to real market prices of electricity.

In all liberalized markets of Europe the goal is to achieve a fully liberalised power exchange. The exception is the United Kingdom (England and Wales) where market is dominated by a pool model. The following chapter explains the pool market model, while in section 3.1.2. focus is on power exchanges, showing the way how the market develops to a exchange model and comparing it with previous market models.

3.1.1. Pool model

In the pool model all producers submit their offer stacks into the pool, which produces stacks and then sends dispatch instructions. The pool itself is purely an administrative entity and takes no risks. The basic variants of a pool model are:

Mandatory pool, generation is only allowed through the pool.

Voluntary pool, generators can participate in the pool, or the buyer and seller can request dispatch to meet a bilateral contract between them.

Pool system has been accepted by most Anglo-Saxon countries, predominant is the second option (voluntary pool). Mandatory pool poses many questions over the years related to market efficiency. In the UK (England and Wales) mandatory pool was in the 90’s regularly referred as an exemplary example of an organised electricity market. It was abolished and a new system based on the model of a bilateral market was introduced NETA (New Electricity Trading Arrangements).

Protection from variations in market prices is realized through short-term and long-term financial bilateral contracts (futures and forward contracts), but usually based on CFD principle ("Contract for difference").

A contract for difference (CFD) is a financial transaction between two parties who do not necessarily have anything to do with the ESI. There is no explicit connection between the CFD market and the system operator, and there is generally no market operator. With no

explicit connection to the market, the system operator is not obliged to making changes to the index, and this gives basis risk to CFD participants. The transaction is in the form of a ‘fixed for floating swap’ which are common in the financial markets. The transaction is as shown in Figure 3-1. The price F is fixed, whereas the price PPP is ‘floating’ until the agreed indexation date is reached. This can be understood by regarding the swap as two separate energy contracts. One is the sale of physical energy at a fixed price and the other is a purchase of physical energy at a floating price.

other is a purchase of physical energy at a floating price. Figure 3-1. CFD as two

Figure 3-1. CFD as two separate energy contracts. Q is the energy volume in MWh

The usefulness for generators and consumers/suppliers is shown in Figure 3-2. The generator A, if dispatched, receives the PPP from the system operator, and this serves as an index. Supplier B pays an uplift on PPP to pay for transmission, distribution and other services. The net result is that B always pays a net price of Q(F+uplift) and hence retains no risk to PPP. The risk to change in uplift is called basis risk. A, if dispatched, receives a revenue of QF and hence is insulated from changes to PPP, provided that PPP exceeds the offer price into the pool.

provided that PPP exceeds the offer price into the pool. Figure 3-2. The net result of

Figure 3-2. The net result of participation in the pool and transaction of a CFD

3.1.2. Power exchange

We have noted that with the exception of the change from bundled centrally managed (effectively a communist model) to unbundled centrally managed, that each structural step in the development of the ESI market is relatively slight. The growth of power exchanges is the slightest of all, but finally bridges the gap between electricity is a intractably complex product

for true competitive wholesale trading, to markets tradable by financial counterparties such as commodity traders, funds, investment banks and actively hedging consumers.

Since not only do definitions of entities vary widely from country to country but from model to model we use stylised definitions for the purpose of these figures:

MO Market operator. Financial reconciliation only;

SB Single Buyer. Economic optimiser;

SO System Operator. Managing the physical system from a starting point of physical notifications;

PX Power Exchange Introducing agent, financial clearing house, physical notification agent;

PN Physical notification Agreed volume submitted to system operator.

In the simplest pool with no demand side participation, Generators submit offer stacks to SB, who constructs a trial schedule using consumption history and submits this to SO, which then manages the imbalance with positive and negative reserve and capacity contracts. A financial power exchange, not integrated with the MO, can operate effectively for contracts for difference in this environment since there is an effective market index. In the absence of the pool index the non integrated PX is vulnerable to index basis, definition, change of definition and illiquidity.

basis, definition, change of definition and illiquidity. Figure 3-3. Pool. No demand side participation [1] With

Figure 3-3. Pool. No demand side participation [1]

With the addition of mandatory demand side participation (no bid no energy), SB no longer estimates demand. Commercial mechanisms for demand imbalance are required. Figure 3-4.

Figure 3-4. Pool model with mandatory demand side participation [1] In the bilateral model, participants

Figure 3-4. Pool model with mandatory demand side participation [1]

In the bilateral model, participants trade with each other instead of the single buyer. Since the bilateral contract is effectively a ‘PN promise’, then reconciliation is required with the market operator.

then reconciliation is required with the market operator. Figure 3-5. Bilateral mechanism [1] The simplest power

Figure 3-5. Bilateral mechanism [1]

The simplest power exchange is simply an introducing function between participants. This part can be played by brokerage companies which need not have more resource than one person with one telephone.

Figure 3-6. Power exchange, just acting as a broker [1] A formal power exchange (the

Figure 3-6. Power exchange, just acting as a broker [1]

A formal power exchange (the standard interpretation of the term), acts as counterparty, and must therefore reconcile trades.

acts as counterparty, and must therefore reconcile trades. Figure 3-7. Power exchange, acting as financial counterparty

Figure 3-7. Power exchange, acting as financial counterparty [1]

An integrated power exchange (the most advanced model, figure 3-8.) submits notifications in relation to the net position from trades executed. If bilateral trades (not shown below) are required to be ‘posted’ or ‘crossed’ on the exchange, then the exchange is very similar to the single buyer but is driven to reflect market conditions rather than proprietary estimates. In France for example, bilateral trades are submitted directly to SO (RTE, an administrative division of Electricité de France) and trades with Powernext are submitted to SO by Powernext.

Figure 3-8. Power exchange, integrated with system operation [1] The basic commodity is the same

Figure 3-8. Power exchange, integrated with system operation [1]

The basic commodity is the same in all cases a hourly (or other period) electricity notification commitment to the system operator. Power exchanges can differ widely in their details:

Counterparty visibility Whilst it is technically possible for counterparties to identify each other in some exchange models, the standard arrangement is that contracts are anonymous.

Auction mechanism The exchanges generally hold an array of bids and offers from participants, that form the production and demand stacks. This can be published in full (with anonymity) or just the most recent trade, the highest bid and the lowest offer.

Credit arrangements The exchange requires capital to maintain a very high credit rating, which is generally (but need not necessarily be) provided by participants. Trades also require initial margin and variation margin. Margin requires complex algorithms for electricity.

Licence restrictions An exchange may be limited by rules beyond the exchange. For example, while a generation or supply license may not be required, registration with a financial regulator may be.

Location Liquidity is concentrated by trading at exchange hubs. Clearly, pricing is of postage stamp form within a hub. Exchanges can trade several locations at the same time, including locations in neighbouring markets.

Live trading or day ahead Whilst exchanges are best suited for live trading, they can operate in batch mode in a pool-like manner. This is essentially a pool model with

demand side participation. Since pool markets produce high quality indexes (i.e. with high concentration of indices), then the index is amenable for exchange traded financial contracts for difference.

Index construction and publication Indexes can be published and could be for example, the closing trade, a weighted average of trades near the close, an average of unaccepted bids and offers, etc.

Financial derivative contracts For example European options cashed out against the index, average rate options, multi-commodity options, time spread options

3.2. European power exchanges

The European Energy Exchange EEX is an electronic exchange based in Leipzig, for trading electricity and related products. Since its inception in 2002, EEX has evolved from a local to the current leading European power exchange. It is made up of several companies that establish international partnerships and thus a wider network to trade energy products. Market operator is a private company EEX AG. EEX is analysed in detail in chapter 3.3. (and chapters 3.4 and 3.5.).

EEX AG. EEX is analysed in detail in chapter 3.3. (and chapters 3.4 and 3.5.). Figure

Figure 3-9. Main trading area on EEX [2]

Nord Pool market, the electricity market of the Scandinavian and Baltic countries, founded in 1993, is currently the largest spot market in Europe. Spot Market ("Nord Pool Spot") is organized through trade on day-ahead and intra-day markets. In 2013, the spot market recorded a trade of 493 TWh. Of the total electricity consumption of Scandinavian and Baltic countries, 84% is purchased on the Nord Pool Spot market in 2013. Until recently there was no derivatives market, but Nord Pool Spot in cooperation with the company "NASDAQ OMX Commodities" created a market in financial derivatives based on prices from the spot market.

financial derivatives based on prices from the spot market. Figure 3-10. Nord Pool market [4] IPEX

Figure 3-10. Nord Pool market [4]

IPEX (Italian Power Exchange) is the Italian electricity market established in 2004. With the goal of Italian market liberalization, competition was created in the spot market. The volume of trade is not nearly as big as on EEX or Nord Pool markets, but it is constantly growing with a steady increase in market participants.

Powernext is the French electricity exchange, founded in 2001, which offers trading on the spot market and the derivatives market. Spot market is organized by "EPEX SPOT" and derivatives markets is organized via the "EEX Power Derivatives." Market operator is a private company Powernext SA, which shares ownership with EEX AG in EPEX SPOT, and has a 20% stake in the "EEX Power Derivatives."

APX is a transparent electricity market of Great Britain, the Netherlands and Belgium, which offers trading on the spot market. In cooperation with the European Commission in 2004, APX has launched a triple market coupling connecting the French, Belgian and Dutch spot market. Market coupling of the specified countries implies joint bids for sale and purchase on the spot market, taking into account the network transmission capacity of these countries.

the network transmission capacity of these countries. Figure 3-11. APX electricity market [5] Belpex is the

Figure 3-11. APX electricity market [5]

Belpex is the Belgian electricity exchange established in 2006 that offers trading on the spot market. An important feature of this exchange is associated trade of electricity on a day- ahead spot market with two neighbouring exchanges, APX Exchange in The Netherlands and Powernext exchange in France. The correlation between the prices on these exchanges is 90% which is the highest recorded market coupling of electricity exchanges. Belpex SA, the operator of Belpex Stock Exchange, is 100 % owned by the APX exchange.

Endex ("European Energy Derivatives Exchange") is the Dutch electricity market established in 2002 with headquarters in Amsterdam, which offers only trade of futures

contracts of electricity. Participants of Endex exchange are manufacturers, distribution companies, financial institutions, industrial consumers, "hedge" funds, asset managers, etc.

Omie is the operator of the Spanish spot market, and OMEL is the system operator responsible for the functionality of the network and consumer supply security. Trade of Spanish futures contracts is lead by Portuguese company MIBEL. An important factor in the Spanish electricity market is lack of transmission capacity between Iberian Peninsula and the rest of continental Europe. Market coupling with the Spanish market would not have satisfactory results until the completion of additional transmission network facilities which would increase transmission capacity with the rest of Europe.

EXAA is the Austrian electricity market established in 2002. The number of market participants has increased from the initial 10 to 74 participants from 15 countries. EXAA only offers trading on the spot market on a daily basis.

PXE (Power Exchange Central Europe) is a power exchange of Czech Republic, Slovakia and Hungary established in July 2007. PXE offers trading on spot and futures markets. Trading financial futures is possible only for Czech Republic delivery area.

Towarowa Giełda Energia or Polish Power Exchange – POLPX is Poland's Energy Market, founded in 2000, which offers trading on the spot market and futures market of electricity. Due to the lack of liquidity in the futures market, futures trading in Poland Stock Exchange was discontinued in June 2006 and was reinstated in 2008.

was discontinued in June 2006 and was reinstated in 2008. Figure 3-12. Average prices for first

Figure 3-12. Average prices for first 17 days of NWE market coupling project [6]

With constant strive for connecting the electricity markets, on February 4, 2014, began a project to connect the north-western European markets - NWE (North-Western European Price Coupling). The largest four spot markets in Europe: EPEX SPOT, Nord Pool Spot, APX and Belpex and 13 system operators from France to Finland, successfully launched market coupling of the day-ahead spot market. Figure 3-12. presents the average realized prices on the spot market for different areas of delivery, in the period from 5 February to 21 February 2014. With this project Denmark, a country that is located between two largest spot markets in Europe, achieved the best results, and the lowest price of electricity (€ 28.64 for 1 MWh).

3.3. European Energy Exchange EEX

As previously mentioned, the EEX AG is made up of several companies that establish international partnerships and thus a wider network for trading energy products. Figure 3-13. shows EEX Group and EEX AG shares in individual companies.

EEX Group

„European Energy Exchange AG” – EEX AG

EEX Group „European Energy Exchange AG” – EEX AG European EEX Power EGEX European Gas Commodity
EEX Group „European Energy Exchange AG” – EEX AG European EEX Power EGEX European Gas Commodity
EEX Group „European Energy Exchange AG” – EEX AG European EEX Power EGEX European Gas Commodity
EEX Group „European Energy Exchange AG” – EEX AG European EEX Power EGEX European Gas Commodity
European EEX Power EGEX European Gas Commodity Clearing Derivatives GmbH Exchange GmbH AG 80% 100%
European
EEX Power
EGEX European Gas
Commodity Clearing
Derivatives GmbH
Exchange GmbH
AG
80%
100%
98.5%
European
Commodity Clearing
Luxembourg
100%
Global Environmental Exchange GmbH 100%
Global
Environmental
Exchange GmbH
100%
EPEX SPOT SE 50%
EPEX SPOT SE
50%
Cleartrade Exchange Pte Ltd. 52%
Cleartrade Exchange
Pte Ltd.
52%

Figure 3-13. EEX group [7]

For trading electricity, the most important three companies are:

EPEX SPOT SE Operator of electricity spot market "EPEX SPOT". Ownership is divided between companies EEX AG and Powernext SA. There are spot markets for France, Germany / Austria and Switzerland.

EEX Power Derivatves GmbH Operator of futures market for Germany/Austria (Phelix Futures), France and Italy, and options market for Phelix futures. Operator of

physical futures market for France, Netherlands and Belgium. It is possible to register a base load futures contract for Switzerland, Spain, Romania and Nord Pool market.

European Commodity Clearing (ECC) AG Banking company owned by EEX AG that offers execution of all financial and physical transactions on EEX. Guarantees the payment and delivery of electricity to all market participants. It offers registration of bilateral agreements on the exchange.

offers registration of bilateral agreements on the exchange. Figure 3-14. EEX trading participants by country [3]

Figure 3-14. EEX trading participants by country [3]

Physical futures contracts at expiry are realized through physical delivery of electricity. Financial futures contracts at expiry are realized through financial compensation between the price at expiration and the price at which the contract was concluded, and can be implemented as a physical futures contract through the spot market. The total volume of trade with power derivatives on the EEX exchange in 2013 was 1,264 TWh, while the spot market recorded a trade volume of 346 TWh [3]. For comparison, the Nord Pool spot market recorded a trade volume of 493 TWh in 2013. Power derivatives and the number of market participants is what makes EEX the current leading power exchange in Europe.

Figure 3-15. Greater trading area on EEX [2] In following chapters, the structure of both

Figure 3-15. Greater trading area on EEX [2]

In following chapters, the structure of both spot and derivatives market (futures and option contracts) is explained. As a reference market EEX was chosen, because it has the greatest potential for expansion, due to well-structured derivatives market, a growing number of market participants and a stable growth of trade volume.

3.4. Spot market

Financial spot markets and spot commodity markets are generally well-organized markets in which goods and money are delivered immediately after the transaction on the exchange. Due to high transaction costs, the spot market typically offers only standardized products for trade in goods.

Electricity spot market is not organized as a market with delivery immediately after transaction. Due to the impossibility of storing electricity, instant delivery is possible only in exceptional circumstances. Therefore, spot electricity market can be divided into two distinct markets: the day-ahead spot market and intraday spot market.

Trade at the day ahead spot market is organized on power exchanges under the principle of equalization of supply and demand for each hour of the following day. The offer comes from the surplus production that can not be sold in the long term. It is similar to the demand, as in the case of unforeseen loads and demand, traders and large consumers can purchase additional electricity on the spot market. In some cases, the manufacturer buys electricity because it can not fulfil its contractual obligations or if the market price is lower than the costs of production units.

Trading products on the day ahead spot market has been standardized and market rules are the same for all market participants, buyers and sellers, which makes the market operator neutral during execution of transactions. Except various delivery periods of electricity, on the spot market base load (electricity supply throughout the next day) and peak load (delivery during peak loads in a day, depending on the market) are traded. The competition between producers, traders, speculators and large industrial consumers is achieved when the submission of tenders for the purchase and sale are delivered to the exchange.

EUR/MWh

100

80

60

40

20

Offers to sell Offers to buy 10 20 30 40 50
Offers to sell
Offers to buy
10
20
30
40
50

MWh

Figure 3-16. Offers for buy/sell of one participant at the day-ahead auction

Each offer contains the quantity and a minimum/maximum price at which a market participant is willing to sell/buy electricity. Immediately after the expiration of the time for sending bids, exchange operator from all of the offers received, forms a supply and demand curve and publishes a determined price for each hour of the following day. Only offers for sale that are lower than the determined price and offers to buy that are above the determined price will be executed, and all of them will be matched at the determined price. This process is called a uniformly valued auction. Figure 3-16. shows offers to buy/sell electricity maid by

one participant of the market for a specific delivery period. Each participant of the market must send their offers.

Intraday market is a market for continuous trade and quick delivery of electricity. A trader can access the market when, for whatever reason, there is an immediate lack of power/energy that should be delivered. This situation demands a quick solution and intraday market serves for that purpose. Prices in this market are significantly higher than on the day-ahead spot market and mainly electricity blocks of one hour are traded.

EPEX SPOT covers the spot market in Germany, Austria, France and Switzerland with headquarters in Paris and offices in Leipzig, Bern and Vienna. The market was created in 2008 by merging companies, and related spot markets, Powernext SA from France and EEX AG from Germany. EPEX SPOT currently has 222 registered participants. The total trade volume recorded in 2013 was 346 TWh, while in Germany/Austria 265.5 TWh was recorded. Compared with consumption in Germany, which in 2013 amounted to 596 TWh, 40% of total electricity consumption in Germany was bought on the spot market. EPEX SPOT market is organized as a day-ahead spot market and intra-day spot market.

EUR/MWh

Offers to sell Offers to buy 6000 7000 8000 9000 10000 DMV
Offers to sell
Offers to buy
6000
7000
8000
9000
10000
DMV

300

200

100

DMP

0

-100

MWh

Figure 3-17. Summarized offers to buy/sell at a determined market price and volume

Day-Ahead spot market is organized through uniform auctions at which all market participants send their offers to buy/sell. After the tenders are received and auction expires, EPEX SPOT summarizes all offers, and after equalization of supply and demand publishes the determined market price (DMP) and determined market volume (DMV) for a specific delivery period. An example is shown in Figure 3-17.

Delivery periods for a particular hour, blocks of several continues hours, base load, peak load and supplies for the weekend are all separately traded or determined from a shorter delivery period. Auctions are held every day and end at noon for Germany/Austria and French area, while in Switzerland ends an hour earlier, and the results are published soon after (usually 15 minutes after).

results are published soon after (usually 15 minutes after). Figure 3-18. Prices for each hour on

Figure 3-18. Prices for each hour on the Germany/Austria spot market from 2000. to 2014.

Offers to buy/sell contain up to 256 combinations of price/quantity of MWh for delivery in one hour of the following day, while prices for 1 MWh must be in the range from -500 €/MWh to 3000 €/MWh. Minimal trading increment for delivery quantity is 0.1 MW, and minimal trading increment for the price is 0.1 €/MWh. EPEX SPOT is the first power exchange which introduced negative rates in 2008, starting with the day-ahead spot market in Germany/Austria. Negative prices are not a theoretical concept. The buyer on the spot market receives electricity, and if the price is negative, receives money as well. Figure 3-18. shows

prices from the day-ahead spot market in Germany/Austria for each hour of delivery from the creation of EEX spot market in Germany, from 15 June 2000. to 27 June 2014.

Market prices move in line with demand and supply of electricity, which is determined by several factors such as climatic conditions, seasonal factors and consumer behaviour. Prices are falling in the case of low demand, and falling into negative territory when inflexible consumer can not be quickly and cost-effectively turned off and back on. Negative price signals producers to reduce production and to compare the costs of turning the power plant off and back on later with costs of selling electricity at the negative price. Renewable energy sources (wind and solar power) also contribute to the decline in market prices in the case of low demand, because of their rights of first purchase and production dependence on hardly predictable external factors (wind and solar).

on hardly predictable external factors (wind and solar). Figure 3-19. German delivery zones with their transmission

Figure 3-19. German delivery zones with their transmission system operators (TSOs) [8]

Location of delivery and trade of electricity on the spot market is defined by zones of transmission system operators. When sending offers to an auction zone of delivery must be specified in the offer. In France there is only one zone of delivery under the control of the French system operator "RTE". In Switzerland, there is also only one zone of delivery under the control of the Swiss system operato "Swissgrid". In Germany, there are 4 different zones with 4 separate transmission system operators: Amprion GmbH, Tennet TSO GmbH, 50Hertz

Transmission GmbH and TransnetBW GmbH. Austria has only one zone of delivery with TSO Austrian Power Grid. These 5 delivery zones in Germany/Austria form a single zone for the formation of the final price on the auction, or the same price for all zones.

Trade with blocks of electricity is based on a combination of several hours of delivery. Offers must be sent to auction where the quantity of delivery does not have to be the same for each hour of delivery within the block. Offer/transaction of the entire block will be executed on the exchange for all specified hours of delivery in the original tender or it will not be executed. Trade of particular hours of delivery has a higher priority than a trade of block, as the price of blocks is based on the determined prices for delivery periods of one hour. Block price offer is compared with the realized volume-weighted average market prices of hourly delivery periods contained in the block. On that basis it is determined whether the block transaction will be executed or not.

Table 3.1. Standard block offers and prices in Germany/Austria, 2014. [9]

Blok prices

23. June

24. June

25. June

26. June

27. June

28. June

29. June

Monday

Tuesday

Wednesday

Thursday

Friday

Saturday

Sunday

Middle Night

             

(01-04)

23.14

29.1

28.71

29.57

29.77

30.28

25.78

Early Morning

             

(05-08)

28.57

34.48

33.79

34.56

33.68

28.05

21.78

Late Morning

             

(09-12)

35.03

50.6

44.87

45

44.2

32.17

28.96

Early Afternoon

             

(13-16)

36.25

43.75

40.11

41.44

37.56

29.67

28.54

Rush Hour

             

(17-20)

44.01

41.11

40.94

46.1

38.83

33.52

29.64

Off-Peak 2

             

(21-24)

40.17

39.04

38.92

41.7

38.85

34.68

33.33

Night

             

(01-06)

22.77

28.88

28.42

29.18

29.4

29.22

24.72

Off-Peak 1

             

(01-08)

25.86

31.79

31.25

32.06

31.72

29.17

23.78

Business

             

(09-16)

35.64

47.18

42.49

43.22

40.88

30.92

28.75

Off-Peak

             

(01-08 & 21-24)

30.63

34.21

33.8

35.27

34.1

31

26.96

Morning

             

(07-10)

35.11

44.68

42.32

43.25

41.83

30.67

23.7

High Noon

             

(11-14)

35.34

49.45

42.93

43.06

41.69

31.37

30.67

Afternoon

             

(15-18)

38.46

40.36

39.31

42.17

35.8

29.75

27.29

Evening

             

(19-24)

42.74

40.18

40.1

44.07

39.64

35.16

32.86

Sun Peak

             

(11-16)

35.81

46.62

41.68

42.36

39.51

30.44

29.52

On the intraday spot market, introduced in 2006, electricity is traded continuously up to 45 minutes (Germany and France, while in Austria and Switzerland, 75 minutes) before delivery. Continuous trading is available for Germany, Austria, France and Switzerland, with similar rules and characteristics for all four markets. The most advanced is the German intraday spot market which rules and characteristics are discussed below.

The minimum trade volume increment is 0.1 MW, with a minimum price increment of 0.01 €/MWh and allowed price range from € -9999 to 9999 €. With standard hourly deliveries of electricity and blocks for base load (from 1 to 24 hours) and peak (from 9 to 20 hours every day) load, on the German intraday spot market even 15-minute delivery periods are traded. Starting every day at 15 o'clock continuous trading for delivery the following day is conducted in hourly, 15-minute or block deliveries up until 45 minutes before the delivery. Besides the standard blocks of delivery, market participants can create their own delivery blocks consisting of several consecutive hours by choice.

Continuous trading is very different from an auction mechanism. Trading is mostly done electronically. When sending a offer to buy/sell for a specific delivery period, price and quantity of delivery must be specified and if there are other offers to sell/buy at that price and with sufficient quantity, the transaction will be immediately or partially matched without any price determination by the exchange. Almost always there is an immediate best open offer to sell ("ask") and buy ("bid") at which transactions can be matched. Trader may decide that he does not want to buy at the current price and gives the order to buy at a lower price and waits for his open order to be matched, and the same goes for the opposite. There are several types of offers which can be sent to the exchange with different modes of execution. Offer types for the German intraday market are:

Limit order Offer to buy/sell that can only be matched at the determined or better price, depending on whether it is an offer to buy, then the better price is the lower one, or offer to sell, then the better price is the higher one.

Market Sweep Order Offer to buy/sell seeking the best deal in a given zone of delivery, but also in other areas and countries.

10th MW Orders Bids for buy/sell of an extremely small volume of delivery from 0.1 to 0.9 MW.

Methods of offer execution are:

Immediate or cancel (IOC) The offer will be immediately matched when sent, otherwise it will be cancelled.

Fill or Kill (FOK) Similar to the IOC with a difference that offer must be fully matched at the determined or better price. There should be enough volume for the offer to be fully matched, otherwise it will be cancelled.

All or None (AON) The offer will be received by the exchange and will be fully matched at the given price or better, otherwise it remains as an pending offer on the exchange until it is fully matched.

IcebergOne big offer which is divided into several smaller offers, usually with the help of automated programs for the purpose of concealing the actual amount of the offer, in this case the amount of MWh.

actual amount of the offer, in this case the amount of MWh. Figure 3-20. Prices on

Figure 3-20. Prices on intraday spot market in Germany on June 24, 2014th

Prices on intraday spot market can fluctuate greatly depending on the needs for balancing the delivery and other unpredictable factors. Figure 3-20. shows the highest, lowest and last price of matched transactions for the supply of power by the hour in Germany on June 24. For example, the delivery of electricity in a period 08-09 hours, the lowest matched price is below 30 €/MWh, and the highest, is around 45 €/MWh.

Difference in matched prices of 15 €/MWh for the same delivery hour, which is 50% with respect to the lowest matched price, indicates high volatility on intraday spot market. Market participants can take advantage of high volatility for the sale of contracted deliveries from the day-ahead spot market at higher prices, if the delivery can be covered in a different way or if it is a surplus. In the case of higher prices, producers can sell excess electricity which they currently have available or if they failed to sell on the day-ahead spot market or bilaterally. Market participants, traders or consumers who have unpredictable demand and/or did not meet their needs to deliver from the day-ahead spot market or bilaterally, can access the market and secure a sufficient amount of energy to deliver. Excessive demand is often on the intraday spot market, and with it a higher price than on the day-ahead spot market for the same delivery period. With the introduction of even shorter delivery period (15 minutes was introduced in Germany and Switzerland) it is now more possible to better balance the unpredictable demand and production from renewable energy sources, and therefore the prices on the intraday spot market. In order to reduce price volatility in both spot markets and increase the delivery quality of electricity, market coupling has been introduced.

quality of electricity, market coupling has been introduced. Figure 3-21. Balancing price between areas with different

Figure 3-21. Balancing price between areas with different supply/demand [10]

Connecting a day ahead spot market mostly works on an auction basis, taking into account the transmission capacity between countries. In the lower price area the demand curve shifts to the right, and in the area of higher prices supply curve also shifts to the right by the amount

of transmission capacity between areas. The result is a balance between price areas. Figure 3- 21. shows an example of balancing prices between two day-ahead spot markets.

Market coupling of day-ahead spot markets on EPEX SPOT exchange is held every day starting at 9:30 - 11:15 am. Delivery contracts of one hour are traded. Auction forms are:

EPEX SPOT France to Germany delivery from France to Germany

EPEX SPOT Germany to France delivery from Germany to France

EPEX SPOT France to Belgium delivery from France to Belgium

EPEX SPOT Germany to Netherlands delivery from Germany to Netherlands

EPEX SPOT France to Spain delivery from France to Spain

EPEX SPOT France to UK delivery from France to UK

EPEX SPOT Germany to Denmark delivery from Germany to Denmark

Denmark to EPEX SPOT Germany delivery from Denmark to Germany

Market coupling of intraday spot markets between EPEX SPOT markets/countries is based on active and continuous linking offers to buy and sell, taking into account the transmission capacity between countries. Without market coupling markets in Germany, the visible supply and trade exists only between consumers, producers and retailers from the German delivery area (local area). By connecting the German and French markets, continuous trading for the German area has local offers and best offers to buy/sell from France and conversely, but only if there is available transmission capacity between countries. The aim is to decrease price differences between countries so there are no additional costs for the purchase/sale of electricity, or for the transmission of electricity between countries. In trading on the exchange, if both parties of the transaction are from the same delivery area, further delivery process is relatively simple. In the case of trading between countries, it is necessary, at all times, to amend the automatic transmission capacity between countries and an active communication between TSO of the countries. In both cases, the registration of trade and delivery is regulated by ECC AG (European Commodity Clearing) company.

The total trade volume of 16.3 TWh on intraday spot market in 2013 is considerably lower then the trade volume on the day-ahead spot market (330 TWh). Hereinafter, day-ahead spot market will be considered as spot market.

At the end of each auction on the spot market, certain prices for each hour are used for indexes that represent the price for a period of delivery in a given area. For the German/Austrian delivery area Phelix index is computed, as Phelix Base and Phelix Peak

index. Phelix Day Base index represents the base load for one day and it is calculated as the arithmetic average of all hourly prices (0-24) for delivery determined on the auction. Phelix Day Peak index represents the peak load for one day and it is calculated as the arithmetic average of the hourly prices for delivery from 8 to 20 hours determined on the auction. With daily indices, there are also monthly indices, Phelix Base Month and Phelix Peak Month, which are calculated as the arithmetic average of all daily Phelix indexes in the month. Figure 3-22. shows the Phelix Day Base index as the average hourly prices of each day from 2000 to 2014. Most other indices are calculated according to the similar or the same principle.

calculated according to the similar or the same principle. Figure 3-22. Phelix Day Base index from

Figure 3-22. Phelix Day Base index from 2000. to 2014.

Market coupling has reduces volatility, as can be seen in Figures 3-18. and 3-22. Following the introduction of negative prices in 2008, the number of price jumps on levels over 100 €/MWh has decreased. With negative jumps becoming more rarer, the price has stabilized in the last few years on levels between 30 and 50 €/MWh. Figure 3-23. shows the frequency histogram of Phelix Day Base index during the period from 2000 to 2014 with a sample of 5125 prices. The histogram would be approximately normally distributed according to the Gaussian curve if there were no prices prior to 2009. Frequency histogram of the prices for the period from 2009 to 2014 with a sample of 2000 prices is shown in Figure 3-24.

Figure 3-23. Frequency histogram of Phelix Day Base index from 2000. to 2014. Figure 3-24.

Figure 3-23. Frequency histogram of Phelix Day Base index from 2000. to 2014.

histogram of Phelix Day Base index from 2000. to 2014. Figure 3-24. Frequency histogram of Phelix

Figure 3-24. Frequency histogram of Phelix Day Base index from 2009. to 2014.

Phelix peak index should always be greater than Phelix base index because it is generally higher average demand for electricity from 8 to 20 hours than the average demand throughout the day. Appearance of the Phelix Day Peak frequency histogram is relatively the same as for the Phelix base index.

is relatively the same as for the Phelix base index. Figure 3-25. Phelix Day Peak index

Figure 3-25. Phelix Day Peak index from 2000. to 2014.

With the increasing construction of photovoltaic power plants in Germany and the current installed capacity of 36 GW [11], during sunny days peak price is more often lower than the base price of the index. Production capacity of renewable and conventional sources of electricity is growing from year to year and currently equals 171 GW in Germany. An average load of 50 to 70 GW, share of production from renewables equals 25.4% and 74.6% from conventional sources. Increasing production capacity with insufficient increase in spending and the right of pre-emption of photovoltaic power has changed the way electricity markets function. Figure 3-26. shows the production from photovoltaic power plants in Germany in one day, June 26, 2014. Figures 3-27. and 3-28. show the percentage price difference between peak and base Phelix Day indexes. During the summer months, from May to October, there is less difference between peak and base index, and on sunny days it is often that peak index is lower than the base index. During winter months, the difference between indexes generally ranges from 5 to 15 €/MWh last 5 years, with occasional jumps above 20 €/MWh.

Figure 3-26. Production from photovoltaic power plants in Germany, 26 June 2014 [11] Figure 3-27.

Figure 3-26. Production from photovoltaic power plants in Germany, 26 June 2014 [11]

from photovoltaic power plants in Germany, 26 June 2014 [11] Figure 3-27. Percentage price difference between

Figure 3-27. Percentage price difference between peak and base Phelix day indexes

Figure 3-28. Percentage price difference between peak and base day indexes last 6 years Peak

Figure 3-28. Percentage price difference between peak and base day indexes last 6 years

Peak and base index and block prices of delivery only take into account average hourly prices within a day, while the cost of hourly electricity supply can vary greatly depending on the market situation. Figure 3-29. shows the average cost of hourly electricity supply on the spot market for delivery in Germany/Austria in each year from 2002 to 2013. From 2002 to 2009 price periodicity is revealed. Lowest price is at 4 am, followed by increase in price to day high at noon, a slight decrease in the afternoon with the leap around 7-8 pm and further drop of prices until midnight. From 2010 till today, price periodicity is the same as for the previous year, but with a smaller price increase during the day due to larger production from photovoltaic power plants than in previous years. The highest price is no longer during the day, but at night at around 8 pm. For the period from 2011 to 2013, price at 8 pm was around 5 €/MWh higher than the price at noon, while the 2010 price at noon and at 8 pm was approximately the same. Figure 3-30. shows the average cost of hourly deliveries in the period from 2002 to 2013, and separately for the period from 2002 to 2009 and from 2010 to

2013.

Figure 3-29. Average prices of hourly deliveries per year 44

Figure 3-29. Average prices of hourly deliveries per year

Figure 3-30. Average prices of hourly deliveries Prices also vary depending on whether it is

Figure 3-30. Average prices of hourly deliveries

Prices also vary depending on whether it is a business or non-business day. Figure 3-31. shows the average electricity price in Germany/Austria by days of the week for each year from 2002 to 2013, and Figure 3-32. shows the average price per day of the week for period from 2000 to 2014. Figure 3-33. represents the average hourly price by delivery days of the week for 2013.

Figure 3-31. Average price per day of the week 46
Figure 3-31. Average price per day of the week 46

Figure 3-31. Average price per day of the week

Figure 3-32. Average price per day of the week from 2000 to 2014 Figure 3-33.

Figure 3-32. Average price per day of the week from 2000 to 2014

3-32. Average price per day of the week from 2000 to 2014 Figure 3-33. Average prices

Figure 3-33. Average prices of hourly deliveries by weekdays in 2013

3.5.

Derivatives market

Due to high volatility in the spot market, market participants are exposed to risks when trading on the spot market. The most important are the price risk, counterparty risk and volume risk (ex. lack of liquidity in the spot market). With long-term contracts, which until recently were not present on most power exchanges, derivatives market provides market participants ability to protect and manage their risks. Long-term contracts bind contract parties to deliver electricity (the underlying), during a given period in the future (delivery period), and are known as derivatives.

Derivative is a special type of contract that has a current value based on expected future price movements of the underlying asset. Derivatives are traded for:

Hedging, risk management

Arbitrage

Speculation

Market participants, producers, traders and large consumers, are using derivatives to hedge against risk. Futures contracts can be bought to hold a long position, or sold before bought to hold a short position. For example, the short futures contract can be used as a protection against falling electricity prices by fixing the price for delivery in the future (the futures price). Arbitrageur exploits the difference between prices in different markets on the same tradable asset class. For example, the simultaneous purchase of a contract for supply of electricity out of the market (bilaterally) at a reduced price and selling futures contracts on the market at a higher price. Speculators trade derivatives in order to achieve profit by taking on the risk of future price movements, thus providing liquidity to other market participants.

Power exchanges use many types of derivatives, but the most common are:

Futures contracts

Forward contracts

Options

In addition to these there are many other derivatives, standardized and non-standardized. For the purpose of describing the electricity exchange EEX only standardized derivatives of EEX exchange are taken into account, while non-standardized derivatives, mostly bilateral, are not taken into account.

3.5.1.

Futures contracts

A typical futures contract is a standardized, portable and binding contract to buy or sell a specific amount of the underlying asset at a certain time in the future (the maturity of the futures contract) at a specified contract price (futures price). Future contracts are used mainly to reduce the risk future market prices by fixing the price to be paid/received for the delivery of the underlying asset in the future. The risk for a buyer or a seller of a futures contract is the same, because the amount of loss and gain of contract participants is the same (but opposite) at any given time until expiry of the contract.

Expiries of futures contracts and the amount of supply of the underlying are standardized. The only debatable aspect of the contract is the current price to be paid for the underlying at some point in the future, or futures price. Contract Standardization is carried out in order to facilitate trade in futures markets.

Future price at time t for delivery of the underlying asset, with the price on the spot market S(t) and the expiration of the contract at time t, is expressed as f (t,T). Payment (P) of a futures contract at expiration T is expressed as:

(

)

(

)

(3.1)

To avoid arbitrage, from relation above we see that the futures price agreed at the time T, for the delivery of the underlying asset at the time T (instant delivery), must be equal to S(T). Any other price would allow arbitration, by buying the cheaper and selling the other.

Having to pay the contracted futures price in given time in the future, there are no costs of concluding the futures contract. However, due to market conditions, the value of futures contracts change over time. For example suppose that the market participant has a long position for delivery of the underlying asset in the future at a market price of € 100, and the current market value of the contract is 110 €. If market participant sells the contract at the current price, he will realize an immediate profit of € 10 and will no longer have any liability in connection with the delivery of the underlying asset in the future.

The value of each futures contract is recorded at the end of each trading day. This means that financial positions are valued according to current market prices as shown in the previous example. The difference between the price of the previous day and current prices are continuously determined. Profit or loss of a position is added to or subtracted from the account of a market participant. Since there is a risk involved when trading futures, exchanges

are using margin accounts that guarantee that contracts will be respected. Margin is determined by how much money you should have in your account when you trade futures contracts and is usually only couple or more percent of the total futures price, and if the position is in negative territory even more.

Trading futures contracts on exchanges is relatively straightforward and ultimate delivery of the underlying asset rarely happens when the contract expires. Sellers and buyers usually break commitments by exiting their positions prior to the expiration of the contract.

The above-described typical futures contracts differ greatly from futures contracts that are traded on power exchanges. In a typical futures contract underlying asset is being bought/sold and delivered in a given time in the future, or when the contract expires. Power futures contract expiration and delivery do not match. Instead of a specific date of delivery, electricity is delivered through a contractually specified period of time. Contracts with different delivery periods are traded, but the most common periods are one month, quarter and year. Power futures contract is a binding agreement for delivery of the contracted quantity of electricity during the delivery period. Futures contract for delivery in 2015, is a contract which obliges the delivery of 1 MW of power during each hour of the delivery period (in this case during the entire year, and the total energy delivered will be 1 MW ∙ 8760h = 8760 MWh).

The price of a power futures contract at time

is expressed as

(

), where

represents the beginning and

( ), where , payment ( ) for a long position in power futures contract is expressed as:

the end of the delivery period. With spot price represented as

Payment (

( )

(

)

(

)

) for a short position in power futures contract is expressed as:

(

)

(

)

( )

(3.2)

(3.3)

From (3.2) and (3.3) it is clear that the underlying asset of a power futures contract is not the spot price in a given time in the future, but the arithmetic average of hourly spot prices during the delivery period. The above fact makes it difficult to model prices of power futures contracts.

On the EEX derivatives market transactions are executed between anonymous offers received by the Exchange. Buyers and sellers submit their bids to buy/sell with given prices and quantities of a particular futures contract. The principle of trade is similar to the intraday spot market, because it is a continuous trading market. Trade takes place mostly on weekdays, from 8 am to 6 pm.

On EEX Derivatives Market it is possible to trade with:

Phelix base, peak and off-peak futures (financial, possible physical delivery)

French base and peak futures (financial, possible physical delivery)

Italian base and peak futures (financial)

Dutch base and peak futures (physical)

Belgium base and peak futures (physical)

Physical futures contracts are realized through physical delivery of electricity at expiry. Financial futures contracts are realized through financial compensation between the price at expiration and the price at which the contract was concluded, and they can be implemented as a physical futures contract through the spot market. On the EEX derivatives market it is possible to register base financial futures contracts with delivery in Romania, Switzerland, Spain and the "Nordic" delivery area (Scandinavian and Baltic countries). The highest trade volume on the EEX derivatives market is on financial futures market, specifically the market for Phelix futures contracts. In addition to futures contracts, options which have futures contracts as the underlying are traded as well. For now there are only options for Phelix Base futures contract. Because of this, from now on in the thesis, only Phelix futures contracts are discussed.

Underlying asset of the Phelix Base futures contract is the Phelix base index for all days of delivery during the delivery period. Phelix Base Index represents the base load and it is calculated as the arithmetic average of all hourly prices (0-24) for delivery on the spot auction. Underlying asset of the Phelix Peak futures contract is the Phelix peak index for all days of delivery during the delivery period. Phelix peak index represents the peak load and it is calculated as the arithmetic average of peak hourly price for delivery (from 08:00 to 20:00) on the spot auction. Underlying asset of the Phelix off-peak futures contract is the Phelix off- peak index for all days of delivery during the delivery period. Phelix off-peak index represents the off-peak load and it is calculated as the arithmetic average of off-peak hourly prices for delivery (from 12:00 a.m. to 8:00 and from 20:00 to 24:00) on the spot auction.

Delivery periods are: day, weekend, week, month, quarter and year for base and peak Phelix index, while for off-peak index there are only delivery periods for one month, quarter and year. Trade of delivery periods for certain futures contracts is possible for:

Day futures contracts next 34 days

Weekend futures contracts next 5 weekend

Week futures contracts next 4 weeks

Month futures contracts next 9 months

Quarter futures contracts next 11 quarters

Year futures contracts next 6 years

Characteristic of quarterly and annual futures contract is that they are cascading or separating on futures contracts with shorter delivery periods on the third day of trading prior to the start of delivery. Quarterly futures contract is broken down into three monthly futures contracts, and the annual futures contract is broken down into three monthly contracts (January-March) and three quarterly contracts (from April to the end of the year). Quarter and annual futures contracts are traded until separation, and futures contracts with shorter delivery period are traded up to the start of delivery or up to few days before the end of the delivery period, depending on the contract. Monthly, weekly, weekend and daily futures contracts are not cascading. Through them delivery of electricity is conducted (with physical futures contracts) or cash compensation is made (in financial futures contracts).

When trading futures, possibility of arbitration emerges between futures contracts with different periods of delivery for the same delivery period. At the end of each day trading day, if there was not enough liquidity, exchange determines the price for each futures contract while taking into consideration that prices must meet the requirement of inability of arbitration. For example, the following relationships must be valid when determining annual and quarterly price contracts:

For the annual futures contract:

Where

quarter and h is the delivery quantity of the contract.

is the annual futures contract price,

(3.4)

is the quarterly futures price for the first

For the quarterly futures contract:

(3.5)

Where is the quarterly futures price for the second quarter, is the monthly futures price for the forth month, a h is the delivery quantity of the contract. Figure 3-34. clearly presents the overlap between the delivery periods of futures contracts, conditions that have to be met in order to satisfy the condition of no-arbitrage and separation of annual and quarterly futures contract on futures contracts with shorter delivery periods.

2013 (Y13) Q1 Q2 Q3 Q4 M1 M2 M3 M4 M5 M6 M7 M8 M9
2013 (Y13)
Q1
Q2
Q3
Q4
M1
M2
M3
M4
M5
M6
M7
M8
M9
M10
M11
M12
2013 (Y13)
2013
(Y13)
M2 M3 M4 M5 M6 M7 M8 M9 M10 M11 M12 2013 (Y13) Q2 M5 Q3
M2 M3 M4 M5 M6 M7 M8 M9 M10 M11 M12 2013 (Y13) Q2 M5 Q3
Q2
Q2
M5
M5
Q3
Q3
M8
M8
M6 M7
M6
M7
Q4
Q4
M11
M11
M12
M12
M1 M2 M3 M4
M1
M2
M3
M4
M10 M9
M10
M9

Figure 3-34. Cascading futures contracts and no-arbitrage condition [2]

The largest trade volume is on base annual futures, because of hedge trades by producers, consumers and suppliers of power. Figures 3-35. and 3-36. show price movements of base futures contract from 2008 to 2014 for delivery periods from 2010 to 2014. Figure 3-37. presents price movements of base futures contract from 2012 to 27th of June 2014, for the delivery periods from 2015 to 2018.

Figure 3-35. Annual base futures contracts from 2008 to 2010 with different delivery periods Figure

Figure 3-35. Annual base futures contracts from 2008 to 2010 with different delivery periods

contracts from 2008 to 2010 with different delivery periods Figure 3-36. Annual base futures contracts from

Figure 3-36. Annual base futures contracts from 2008 to 2014 with different delivery periods

Figure 3-37. Annual futures contracts from 2012 to June 2014 with different delivery periods Price

Figure 3-37. Annual futures contracts from 2012 to June 2014 with different delivery periods

Price volatility before 2010 is substantially higher than in the coming years. For example, in 2009 a difference of over 15 EUR/MWh was recorded between annual futures contracts for delivery in 2010 and 2014 (difference in the delivery of 4 years), and a difference of 10 EUR/MWh was recorded between annual futures contract for delivery in 2010 and 2012 (Figure 3-35.). Equivalently at the beginning of 2014, the current year before the start of delivery of a futures contract for 2015, the biggest difference of just a few EUR/MWh was recorded between futures contracts for delivery in period from 2015 to 2018. Until April 2014, future contracts with later delivery period had a higher price than future contracts with earlier delivery periods, while the current futures contract with delivery in 2015 has the highest price (Figure 3-37.).

Higher prices of futures contracts with later delivery periods can be interpreted as uncertainty or risk of high electricity prices in the future, which was obviously much higher few years ago than today. Stabilization of prices may contribute to a growing number of market participants, real electricity traders or speculators, and to increased production capacity of renewable energy sources that contributed to higher competition among conventional electricity producers.

Price movements of annual futures contract since 2008 to 27 June 2014 with delivery periods from 2010 to 2018 are shown in Table 3.2. All amounts are in euros and refer to one futures contract with 1 MW of constant delivery during the delivery period. Recorded averages are: lowest price € 38.74, highest price € 80.68, arithmetic mean € 54.53 with a standard deviation of € 10.36 and volatility of 19.7%. Figure 3-38. shows daily price movements on the spot market (Phelix Base day index) and the current annual base futures contract price with delivery in the next year from 2009 to 2014.

Table 3.2. Price movements and averages of annual base futures contracts

Delivery period

Low

High

Arithmetic mean

Standard deviation

Volatility

2010

42.65

89.00

59.20

11.87

20.1%

2011

45.19

89.67

57.91

10.25

17.7%

2012

48.43

90.30

59.32

8.64

14.6%

2013

45.07

96.30

60.03

10.43

17.4%

2014

36.25

96.80

57.54

12.60

21.9%

2015

33.77

72.00

52.78

10.69

20.3%

2016

33.15

68.40

50.83

10.45

20.6%

2017

32.11

65.25

48.59

10.29

21.2%

2018

32.00

58.42

44.61

8.04

18.0%

Average

38.74 €

80.68 €

54.53 €

10.36 €

19.07%

38.74 € 80.68 € 54.53 € 10.36 € 19.07% Figure 3-38. Daily prices on the spot

Figure 3-38. Daily prices on the spot market and current annual futures contract price

3.5.2.

Forward contracts

Like a futures contract, forward contract is a binding agreement to buy or sell a specific amount of the underlying asset at a certain time in the future at a specified contract price. Unlike futures contracts, which are usually traded on an exchange, forward contracts are mostly traded bilaterally and contractors usually adapt the contract to their needs.

Future contracts, as previously shown, are standardized contracts that are traded and priced on exchanges between large number of trading participants. By using margin accounts and exchange as an intermediary for all financial transactions, delivery risk is minimal that futures contracts will not be respected. For this reason an increasing number of bilaterally agreed futures contract are registered on the exchange. Forward contracts are private contractual agreements and contract participants are exposed to the risk that counterparties will not comply with the contract.

Assuming a deterministic interest rate, forward and future contract prices will be same for contracts with the same beginning and delivery period. Therefore only futures contracts traded on the EEX are taken into account.

3.5.3. Option contracts

There are two basic types of options: call and put. A call option gives the holder of the option the right, but not the obligation, to buy the underlying asset at a given time in the future (at option expiry - T) for a price agreed upon purchase of the option (strike price - K, the exercise price). A put option gives the holder of the option the right, but not the obligation, to sell the underlying asset at a given time in the future for a price agreed upon purchase. These options, where owner only has the right to exercise the option on expiration date, are known as the European option. There are many other types of options such as the American options (possible exercise of the option at any time until expiration) and Asian options (option premium depends on previous price movements of the underlying asset).

Options are only traded on exchanges. Basically there are two types of options on power exchanges. European options with futures as the underlying asset and Asian options with spot price as the underlying asset. Highest trade volume is registered on European options with annual base future contracts as the underlying asset and they are considered in this Thesis.

As with classic European option, the owner of an European call option written on power futures contract, has the right, but not the obligation, to buy a futures contract at strike price

when the option expires. If the futures contract price is defined as ( ), payment of a European call option ( ) upon expiration , written on a futures contract with delivery period from to is defined as:

(

(

)

)

(3.6)

Where is hours of delivery of a futures contract on which the option is written (base futures contracts deliver 1 MW during each hour of the delivery period).

Owner European put options written on a power futures contract has the right but not the obligation, to sell a futures contract at strike price when the option expires. Payment of a European put option ( ) upon expiration , written on a futures contract with delivery period from to is defined as:

(

(

)

)

(3.7)

On the EEX exchange, it is possible to trade with European call and put options with Phelix base futures as the underlying asset. There are options written on futures contracts with delivery period of one month, quarter and year. EEX exchange offers additional options with different expiration times written on annual futures contracts. Option expirations are before the start of delivery period of the futures contract (an additional 4 different expiry times). The option will be of value during expiration if the strike price is lower/higher (call/put option) then current market price of the futures contract , according to (3.6) or (3.7), and the owner of the option will exercise it, because it is in the money. If the strike price is lower/higher than the current price of a futures contract on which the options are written (if the option is out of the money) owner of the option will allow the option to expiry without exercising it. If the option has a positive value, the owner of the option will execute the option and now hold the futures contract at strike price that is more favourable than the current price on the exchange.

When buying options, the buyer pays the premium. The option buyer has a theoretical possibility to achieve infinite profits at the risk of losing the premium. The seller receives the option premium when selling options, but there is a theoretical risk of an infinite loss. Actual payment to the option holder is obtained when we take into account premiums paid during purchase (3.6) and (3.7). If you define the call option premium as and call option premium as , the actual payments to the option holder at expiry are defined according to (3.8) and

(3.9).

Actual payment to the owner of the call option:

(

(

(

)

)

)

Actual payment to the owner of the put option:

 

(

(

(

)

)

)

(3.8)

(3.9)

The option premium depends on several parameters such as exercise price, time to expiration, the volatility of the underlying asset, interest rate of the currency in which the underlying asset is traded, and the anticipation of future price movements of the underlying asset. Figure 3-39. shows dependence of the premium price to the strike price, on one trading day June 25 2014, for call options written on annual futures contracts with expiration in 2015 and 2016 (both futures and options). Figure 3-40. shows the equivalent dependence for the put option. Figures 3-41. and 3-42. show movements in premiums for call and put options in 2014, until the end of June, with two different exercise prices (35 and 40 € / MWh) and two delivery period (2015 and 2016). For ease of comparison with the premiums, Figure 3-43. shows price movements of annual futures contracts for delivery in 2015 and 2016.

of annual futures contracts for delivery in 2015 and 2016. Figure 3-39. Dependence of call option

Figure 3-39. Dependence of call option premium on strike price

Figure 3-40. Dependence of put option premium on strike price Figure 3-41. Movement of call

Figure 3-40. Dependence of put option premium on strike price

Figure 3-40. Dependence of put option premium on strike price Figure 3-41. Movement of call option

Figure 3-41. Movement of call option premiums from the beginning of 2014 until July

Figure 3-42. Movement of put option premiums from the beginning of 2014 until July Figure

Figure 3-42. Movement of put option premiums from the beginning of 2014 until July

of put option premiums from the beginning of 2014 until July Figure 3-43. Price movement of

Figure 3-43. Price movement of annual futures contracts

4.

MARKET SIMULATION MODELS

Previous two chapters present a general overview of the liberalized electricity market, as well as insight into spot and derivatives market on EEX exchange. In line with the liberalization process, power exchanges have become a place where manufacturers, distributors, speculators, retailers, traders and large consumers trade different products of electricity. Due to increasing trade volume it has become necessary that market participants develop simulation models for price movements for contracts which they trade in order to apply better risk management strategies and to evaluate there positions on the exchange. This chapter presents a mathematical approach required for understanding, application and development of simulation models for electricity.

Modelling electricity price movements can be achieved through three different approaches:

Fundamental approach

Stochastic approach

Hybrid approach

Fundamental approach is realized through use of fundamental variables for implementation of simulation models that match historical data as closely as possible. It requires high understanding and insight into the variables that influence changes in market prices. The variables that affect the change in electricity prices are: power plant production costs, expected consumption for the delivery period, fuel prices (gas, coal, oil), weather conditions, transmission and installed network capacity, etc. Advantages of fundamental approach are the ability to monitor variables that affect fluctuations in market prices and relatively simple economic explanations for price changes. However, a large amount of data required for model implementation and fitting with historical data, with constantly changing variables (one of which is of great importance - temperature), makes this method very difficult to implement. Therefore, the models for predicting future price movements based on a fundamental approach are not used for periods longer than one week ahead.

Stochastic approach is realized through modelling of stochastic processes that represent electricity prices. Historical data is used to estimate stochastic processes parameters with aim of better matching of simulation model with historical data. Prices of electricity derivatives, such as European options, can be obtained from stochastically modelled price movements of the underlying asset on which the derivative is written. After analysing electricity markets it

can be concluded, with great confidence, that price movements in spot and futures markets are random processes that can be modelled by stochastic processes. Problems of the stochastic approach are lack of historical for accurate estimation of process parameters and on going structural and regulatory changes in the ESI. Yet with all said, stochastic modelling of electricity prices is a very active research and scientific topic.

The hybrid approach is implemented through the combination of fundamental and stochastic approach. Many authors of the hybrid approach and results had shown that hybrid model of electricity prices describes price movements well, even in extreme conditions of sudden changes in fundamental variables (such as weather conditions, extreme load changes, lack of production, and combination of the above).

Fundamental and hybrid approach require large amounts of data and assume an economic connection (correlation) between tradable products on exchanges, which makes simulation models very sensitive to parameter changes. This indicates a high risk of simulation models when fundamental or hybrid approach is applied. In this paper focus is on the stochastic modelling approach of electricity prices using historical data from EEX exchange.

4.1. Stochastic spot price modelling

Stochastic process is a mathematical formulation of a random motion formed by successive random numbers. In this paper only processes that have Markov property were used. A stochastic process has the Markov property if the conditional probability distribution of future states of the process (conditional on both past and present values) depends only upon the present state, not on the sequence of events that preceded it. A process with this property is called a Markov process.

The model we describe in this paper will capture the following characteristics observed in all known electricity markets:

Seasonal patterns and periodicities All markets show seasonal patterns of electricity demand over the course of the day, week and year. Seasonal price movement in the spot market is related to temperature, weather conditions, and other fundamental variables, and it is therefore considered a deterministic characteristics.

Price spikes Relatively frequent occurrence of extreme jumps in price on very high or negative values. The jumps occur for fundamental reasons, but they are often impossible to predict, and are therefore considered a stochastic characteristic.

Mean reversion Prices have the tendency to quickly return from high or negative levels to a mean level. Since jumps are defined as stochastic processes, mean reversion can also be classified as a stochastic process, or a stochastic characteristic.

Price dependent volatilities It turns out that in all markets there is a strong correlation between price levels and levels of volatility.

Long-term non stationarity Due to increasing uncertainty about factors such as supply and demand or fuel costs in the long-term future, a non stationarity model seems more appropriate. Non stationarity is also needed for a model to be consistent with the observed dynamics of futures prices.

Modelling electricity prices can be done using various stochastic processes, some of which do meet the characteristics above and some do not. Most famous, and one of the first stochastic process, is the Brownian motion which describes the movement of random numbers with given mean value and volatility which can have negative and positive values. Geometric Brownian motion (GBM) is considered a more advanced version, but may only take positive values and is therefore widely used in modelling assets and securities on financial markets. Since the introduction of negative values on the exchange, GBM can not be used as a separate process for modelling electricity prices. Even before the introduction of negative prices, these processes had not represented spot prices well, due to lack of mean reversion.

Mean reverting stochastic processes are characterized by a typical mean price to which the process strives, strength or speed of return to the mean price and volatility of the process. The mean price does not necessarily have to be fixed, but may also be a separate function or a process, which represents spot price movements well. The problem with modelling prices with a mean reverting process continues to be sudden jumps in price to extreme levels. Adding stochastic jumps to mean reverting processes achieves satisfactory results.

In addition, the use of models with stochastic volatility instead of fixed volatility can be used in all of these processes. A major problem in stochastic modelling is the determination of process parameters in order to fit simulation model with historical data. Many methods are used to determine the parameters depending on the process being modelled, most of which are extremely complex and difficult to implement, and are out of the scope of this paper. In this

paper, the least squares method and maximum likelihood estimation is used to determine process parameters.

Modelling spot prices can be conducted by first determining the seasonal/periodic component of historical data, so that stochastic process models the rest. By using mean reverting process and modelling mean level as a separate process or floating variable, spot prices can be simulated without prior separation of the seasonal component.

The focus of this paper is to describe the most popular stochastic processes used to model the movement of prices on power exchanges and less on determining the process parameters in order to better fit the model with historical data. Exact matching of models with historical data does not guarantee that process parameters, or the model itself, will be valid in the future. Simulation models are used primarily for risk management and business development, and not to predict future price movements.

The following section explains the most important processes for modelling electricity prices. For comparison with the simulation models historical prices for German /Austrian delivery area were selected (Phelix daily base index), in period from 2008 to June 2014 (Figure 4-1.). Prior to this period there were no negative prices in the market, and because of the fundamental mismatch with the current functioning of the exchange, prices prior to 2008 will not be considered. Price trends on the spot market before 2008 are shown on figures in third chapter.

market before 2008 are shown on figures in third chapter. Figure 4-1. Phelix Base daily index

Figure 4-1. Phelix Base daily index in period from 2008 to June 2014

4.1.1.

Basic statistical analysis

The basis of any data analysis is descriptive statistics which gives insight into data distributions. The most important values are arithmetic mean, standard deviation, coefficient of skewness and kurtosis coefficient.

Mean (average)

for N prices S on spot market is defined as:

Standard deviation

( )

for N prices S on spot market is defined as:

(

( )

)

(4.1)

(4.2)

Asymmetry coefficient (CA) indicates asymmetry around the mean of observed data [12]. Classical normal distribution is symmetric around the mean and has a value of CA equal to zero. If distribution is tilted to the right, or if it has a thicker right end, CA will be positive, and if it is a left end of distribution CA will be negative. CA value of data on the spot market is defined as:

∑ (

( )

CA value of data on the spot market is defined as: ∑ ( ( ) √

)

(4.3)

Kurtosis coefficient (KC) completes the picture of the layout of distribution, because it numerically describes the curvature in the vicinity of distributions peak [12]. Curvature of the normal distribution is equal to 3. In the event that the KC is greater than 3, distribution is more acute, it is narrower and has a higher peak than the normal distribution, and if it is less than 3, distribution is flatter, lower and wider than the normal distribution. KC of prices on the spot market is defined as:

∑ (

( )

∑ ( ( ) √ ) (4.4) By linking these coefficients, "Jarque-Bera" test (JB) is used

)

(4.4)

By linking these coefficients, "Jarque-Bera" test (JB) is used to measure the normality of the observed data [12]. Critical value at which the observed data could be considered normal is 5.99 while JB value of spot price distribution is 1260.9 (Table 4.1) which concludes that observed prices on the spot market are not normally distributed. JB test is defined as:

(

(

)

)

(4.5)

Figure 4-2. shows the distribution of observed prices (blue) and normal distribution (red) with an average value and standard deviation of the observed data (Table 4.1.). Ordinate represents occurrence frequency of a certain price expressed as a percentage, while abscissa represents prices on the spot market in EUR/MWh. Distribution of observed data has a thicker right end which is indicated by a positive CA and narrower and higher peak than the normal distribution as indicated by KC.

higher peak than the normal distribution as indicated by KC. Figure 4-2. Distribution of Phelix base

Figure 4-2. Distribution of Phelix base index prices during the period from 2008 to June 2014

Table 4.1. Parameter values for spot market prices for a given period

 

Standard

Asymmetry coefficient - CA

Kurtosis coefficient - KC

 

Mean -

deviation -

Jarque-Bera test

45.7 €/MWh

15.6 €/MWh

0.54

6.4

1260.9

If we formulate daily returns/moves (DM) of spot prices as:

( )

(

)

( )

(4.6)

Table 4.2. Parameter values for spot market daily returns

 

Standard

Asymmetry coefficient - CA

Kurtosis coefficient - KC

 

Mean -

deviation -

Jarque-Bera test

-1.94 %

43.97 %

7.8

219.03

4.6328e+06

Figure 4-3. shows the distribution of observed daily returns on the spot market (blue) and

normal distribution (red) with an average value and standard deviation of the observed data

(Table 4.2.). For modelling price movements distribution of returns is used more often than

price distribution. Extreme spikes substantially increase standard deviation of returns and it is

obvious that observed returns do not fit the normal distribution.

obvious that observed returns do not fit the normal distribution. Figure 4-3. Distribution of spot price

Figure 4-3. Distribution of spot price daily returns

Continuous monitoring of the mean price for a particular period provides insight into movement characteristics of average levels used in mean reverting stochastic processes where mean levels are not fixed. Figure 4-3. shows moving averages for periods of 30, 60 and 90 days. Shortest moving averages of 30 days follows sudden price changes, while moving averages of 90 days rarely responds to sudden changes in price. If we compare Figures 4-1. and 4-4., we observe that moving averages eliminate the "noise" and clearly show the level at which the price is at a given time. Moving averages of 90 days is the best average price to represent price trends over a period of several days and to point at the huge range of historical prices, and thus representing unpredictability of future price movements.

Continuous monitoring of standard deviation for a certain period, provides insight into movements of volatility of stochastic process that is used in all processes. Figure 4-5. shows trends in standard deviation for a period of 30, 60 and 90 days.

in standard deviation for a period of 30, 60 and 90 days. Figure 4-4. Price moving

Figure 4-4. Price moving averages (MA) of Phelix Base daily index

Figure 4-5. Standard deviation moving averages (MA) of Phelix Base daily index 4.1.2. Brownian motion

Figure 4-5. Standard deviation moving averages (MA) of Phelix Base daily index

4.1.2. Brownian motion

Process of Brownian motion (with drift) S(t) is obtained as a solution of the stochastic differential equation (SDE) with a constant drift and constant intensity of the random component (volatility) . SDE of Brownian motion is defined as [13]:

(

)

(

)

(4.7)

Where

mean zero, variance dt and standard deviation

( ) represents the Wiener process of normally distributed random variable with

, defined as:

(

)

(4.8)

Variable represents a random variable which is, for simulation purposes (in this paper), defined as a sum of twelve random numbers with values ranging from zero to one reduced by six (standard normal distribution). It is defined as:

()

(4.9)

By direct integration of (4.7) solution of the SDE, with intial value S(0):

(

)

(

)

Hence S(t) is normally distributed, with mean is defined as:

( )

is normally distributed, with mean is defined as: ( ) √ ( ( ) ( )

(

(

)

(

)

(

)

and variance

)

(4.10)

. Its density function

(4.11)

A Geometric Brownian Motion S(t) is the solution of an SDE with linear drift and diusion coecients. The GBM is specified as follows:

(

)

(

)

(

)

(

)

(4.12)

In order to solve for S(t) we will apply Ito’s lemma to ln(S(t)) as follows:

 

(

)

(

)

[

(

)]

(

 

(

))

 

(

(

))

(

)

 

(

)

 

(

(

))

   
 

(

(

))

(

)

 

(

(

))

(

)

(

)

 

(

(

))

(

)

(

)

 

(

)

(

)

 

(

)

 

(

)

 

(

)

(

)

(

)

(

)

Hence the first two moments, mean and variance, of S(T) are:

 
 

[

(

)]

(

)

 

[

(

)]

(

)

(

)

(4.13)

(4.14)

To simulate this process, the continuous equation between discrete instants of time needs to be solved as follows:

(

)

(

)

(

)(

)

(

)

(4.15)

The following charts plot a number of simulated sample paths using the above equation for different values of drift. The mean of the asset price grows exponentially with time.

The mean of the asset price grows exponentially with time. Figure 4-6. GBM sample paths Figure

Figure 4-6. GBM sample paths

the asset price grows exponentially with time. Figure 4-6. GBM sample paths Figure 4-7. GBM sample

Figure 4-7. GBM sample expectations (means)

4.1.3.

Parameter estimation

This section describes how the GBM can be used as an attempt to model the random behaviour of spot prices. In order for us to be able to model spot prices with GBM, negative prices from historical data have to be removed (GBM can not be negative if set as positive). There are only 8 days with negative prices and there prices are set to 1 €/MWh. Spot price log returns are shown in Figure 4-8.

The second chart (Figure 4-9.) plots the quintiles of the log return distribution against the quintiles of the standard normal distribution. This QQ-plot allows one to compare distributions and to check the assumption of normality. The quintiles of the historical distribution are plotted on the Y-axis and the quintiles of the chosen modelling distribution on the X-axis. If the comparison distribution provides a good fit to the historical returns, then the QQ-plot approximates a straight line. In the case of the spot price log returns, the QQ-plot show that the historical quintiles in the tail of the distribution are significantly larger compared to the normal distribution. This is in line with the general observation about the presence of fat tails in the return distribution of electricity prices. Therefore the GBM at best provides only a rough approximation for the spot price. The next sections will outline some extensions of the GBM that provide a better fit to the historical distribution.

that provide a better fit to the historical distribution. Figure 4-8. Spot price log returns without

Figure 4-8. Spot price log returns without 8 price negative days

Figure 4-9. QQ plot of spot price log returns Having tested normality for the underlying

Figure 4-9. QQ plot of spot price log returns

Having tested normality for the underlying historical data one can now proceed to calibrate

the parameters

historical dataset the method of maximum likelihood estimation is used (MLE). Let the log return be given as:

(

) based on historical returns. To find that yields the best fit to the

MLE can be used for both continuous and discrete random variables. The basic concept of

MLE, as suggested by the name, is to find the parameter estimates

probability density function

that will maximise the likelihood or probability of having observed the given data sample x 1 ,

for the assumed

(continuous case) or probability mass function (discrete case)

x

2 , x 3 ,

,

x n for the random vector X 1 ,

,X

n . In other terms, the observed sample x 1 , x 2 , x 3 ,

,

x

n is used inside

(

), so that the only variable in f is

, and the resulting

function is maximised in

sample, i.e. the likelihood function, will be denoted by

. The likelihood (or probability) of observing a particular data

(

).

In the GBM case maximum likelihood estimation is done on log returns rather than on the levels. By defining the X as:

 

(

)

(

)

(

)

The likelihood function is defined in general as:

 

(

)

(

)

(

)

(4.16)

(4.17)

The MLE estimate

density values could become very small, which would cause numerical problems with handling such numbers, the likelihood function is usually converted to the log likelihood

is found by maximising the likelihood function. Since the product of

. In this case the log-likelihood reads:

(

)

[

(

)]

(4.18)

Probability density function is defined as (for GBM):

(

(

))

((

(

)

) )

(

(

)

)

is defined as (for GBM): ( ( )) (( ( ) ) ) ( ( )

(

)

The likelihood function needs to be maximised to obtain the optimal estimators The natural logarithm of the likelihood function must be differentiated in terms of

then equated to zero which will yield two equations and must be solved simultaneously to obtain:

(

̂ ̂).

and

Where:

̂

[

̂

̂

]

̂

̂

(4.19)

̂

(

)

(

)

(4.20)

̂

(

̂)

(4.21)

First one needs to determine ̂ and

̂

̂

̂ then the MLE of GBM fitted to spot prices are:

̂

̂

̂

As previously said, GBM does not fit well with historical spot prices, but same procedure of parameter estimation can be used in other models. After determining the probability density function and using MLE, parameters can be estimated by differentiating the likelihood function in terms of process parameters. GBM can be used to independently model futures

prices, because futures price does not exhibit mean reverting behaviour and price spikes as do spot prices.

4.1.4. Mean reverting processes

Process is considered to be mean reverting if with growing distance from the mean level, increases the likelihood of returning to the mean level in the future. A simple example of a mean reverting stochastic process S(t) is obtained as a solution of SDE defined as:

(

)

(

)

(4.22)

Where , , and are constants and ( ) represents an increment to standard Brownian motion W(t). The spot price S(t) will fluctuate randomly, but over the long run tends to revert to some level . The speed of reversion is known as and the short-term standard deviation is where both influence the reversion. This model is also known as Vasicek model, Gaussian model or Ornstein-Uhlenbeck mean reverting process (OUMR).

Solving the Ornstein-Uhlenbeck Stochastic Differential Equation includes taking the

derivative of

( ) which yields:

(

)

Rearranging it:

(

)

Multiplying both sides of equation (4.22) with

to get:

(

)

(

)

(4.23)

(4.24)

(4.25)

By using equation (4.24) and substitute it into equation (4.25):

(

)

(

)

If an integral is taken from time t=0 to t it gives:

(

)

(

)

(

)

(

)

(4.26)

(4.27)

(4.28)

The solution of the stochastic differential equation (4.22) between s and t, if

(

)

(

(

) )

(

)

is:

(4.29)

Integral on the right hand side of equation (4.28) follows a normal distribution with a mean of zero and a variance such that:

[(∫

(

)

(

) )

]

The conditional mean and variance of

[

]

[

]

∫ (

given

(

(

(

)

is:

)

)

)

(

)

(4.30)

(4.31)

(4.32)

If time increases the mean tends to the long-term value and the variance remains bounded, implying mean reversion. The long-term distribution of the Ornstein-Uhlenbeck process is stationary and is Gaussian with mean and variance .

The discrete time version (which can be deduced by the Ito isometry) of this equation with (assume constant for simplicity) time step t:

(

̂

)

̂

̂

̂

(4.33)

Where is independent identically distributed and follows a standard normal distribution with a mean of zero and a variance of one. After rewriting (4.33) to get:

( )

̂

̂

̂

̂

(4.34)

(4.35)

(4.36)

(4.37)

The coefficients c, b and δ are calibrated using the equation (4.34). The calibration process is

simply an OLS (ordinary least squares) regression of the time series

. The OLS regression provides the maximum likelihood estimator for the parameters c, b and δ. By resolving the three equations system one gets the following a, and σ parameters:

on its lagged form

̂

(

)

(

)

(

 

)

(

)

(4.38)

(4.39)

(4.40)

Applying equations above to fit historical spot prices following parameters of mean reverting

process are obtained (with

):

(Figure 4-10.).

mean reverting process are obtained (with ): (Figure 4-10.). Figure 4-10. Mean reverting process fitted to

Figure 4-10. Mean reverting process fitted to historical spot prices

Distribution of simulated mean reverting prices, for 1000 simulations, fitted to historical data is displayed in Figure 4-11. Distribution of daily returns has the same shape (varying from - 20% to 20%).

Figure 4-11. Distribution of 1000 simulated and fitted mean reverting prices Figures above clearly illustrate

Figure 4-11. Distribution of 1000 simulated and fitted mean reverting prices

Figures above clearly illustrate that mean reverting process with a fixed mean (one-factor mean reverting model) does not describe well the movement of prices on the spot market. If we define the mean price as a separate stochastic process model (two-factor model) it will fit historical data well, but we are left with many model parameters that need to be determined. If we model mean price as a GBM we are using the Pilipovic model [15]:

( )

(

)

(

)

(4.41)

 

(4.42)

(4.43)

Deriving the conditional mean, variance and probability density function for two factor mean reverting models is a complex task which goes beyond the scope of this paper. For more information on the matter, please see [15].

For simulation purposes, two factor mean reverting model is used with a stochastic mean modelled as a GBM. Figures from 4-12. to 4-14.

Figure 4-12. Mean reverting process with mean as GBM (red) Figure 4-13. Distribution of 100

Figure 4-12. Mean reverting process with mean as GBM (red)

Figure 4-12. Mean reverting process with mean as GBM (red) Figure 4-13. Distribution of 100 simulated

Figure 4-13. Distribution of 100 simulated mean reverting prices with mean as GBM

of 100 simulated mean reverting prices with mean as GBM Figure 4-14. Distribution of 100 simulated

Figure 4-14. Distribution of 100 simulated mean reverting returns with mean as GBM

For simulation purposes we can also present a two factor mean reverting (MR) model with a stochastic mean modelled as a separate mean reverting process with a fixed mean. Figure 4- 15. presents a MR model with a stochastic mean modelled as a separate MR process (Figure -

16.).

mean modelled as a separate MR process (Figure - 16.). Figure 4-15. Mean reverting process with

Figure 4-15. Mean reverting process with mean as a separate MR process

Mean reverting process with mean as a separate MR process Figure 4-16. Separate mean reverting process

Figure 4-16. Separate mean reverting process corresponding to Figure 4-15.

4.1.5.

Jump diffusion processes

Stochastic processes described so far include most of spot price characteristics other than sudden jumps in price. By adding a jump process we obtain jump diffusion processes that are very complex, have dozens of parameters and are hard to fit to the historical data.

The basic concept of random price movements used so far is normally distributed Wiener process according to (4-8). To incorporate stochastic processes with jumps, an additional concept of random price movements is required. Poisson process (PP) is used to model jumps. Differential of PP is defined as:

{

(4.44)

represents the intensity of PP.

If we add jumps to two-factor mean reverting (MR) model with a stochastic mean modelled as a separate mean reverting process with a fixed mean we acquire the following relations [13]:

Where

is jump probability in time interval dt. Parameter

(

)

( )

(

)

 

(4.45)

(

)

(4.46)

Where J represents a percentage amount of price change if a jump occurs ( ), which can be modelled as a separate random variable. For simulation purposes and for simplicity fixed values of J were taken. Simulation of MR process (blue) with jumps and mean as a separate MR process (red) is displayed in Figure -17.

as a separate MR process (red) is displayed in Figure -17. Figure 4-17. Simulation of two

Figure 4-17. Simulation of two factor MR process with jumps

Deriving the conditional mean, variance and probability density function for two factor mean reverting models with jumps is a very complex task which goes beyond the scope of this paper. To compare with QQ plot of spot price log returns (Figure 4-9.) and distribution of spot price daily returns (Figure 4-3.), following figures are displayed:

returns (Figure 4-3.), following figures are displayed: Figure 4-18. QQ plot of simulated spot price log

Figure 4-18. QQ plot of simulated spot price log returns (one simulation of 2370 days)

spot price log returns (one simulation of 2370 days) Figure 4-19. Distribution of simulated spot price

Figure 4-19. Distribution of simulated spot price returns (one simulation of 2370 days)

Both distribution and qq plot of simulated data show a good model fit with the historical data. Fat tails, created by jumps, are well modelled and returns have a similar distribution with heavy fat tails.

4.2.

Derivatives modelling

Modelling electricity prices is a relatively young research area, but also the most demanding one for analysis and implementation. Previously mentioned models of price movements were originally used as simulation models for stocks, indices, interest rates, oil, gas and other commodities on financial exchanges around the world. Electricity as a commodity has a unique characteristic which no other traded commodity has, and that is the impossibility of storage and delivery over a certain period instead of instantaneous delivery. Modelling of spot prices shown in previous chapter, represents prices that are determined by on day ahead auctions, a day before delivery. Determined daily price for the next day of delivery says nothing about the price next week, month or year. Prices determined on day- ahead auctions represent the price for distinct and separate goods that are delivered and consumed the next day.

Future contract represents the average price of electricity to be delivered over a certain period of time in future. For example, in the case of base futures contract, delivery will be continuous during all hours of the day during the delivery period and the price of futures contract will represent the same price for the entire delivery period. Since the underlying asset of a futures contract is the daily price on spot market, the question emerges on how to connect spot market prices with futures prices. A futures contract is traded for delivery in distant or near future, while on spot market only delivery for one day in advance is traded. Absence of spot market trading for delivery in the same delivery period of the futures contract makes electricity exchange market incomplete, because it is very difficult to accurately link futures price with the current spot price.

In practice, there are two approaches to stochastic modelling futures prices. The first approach is that futures price is linked to the stochastic model of the spot market price (section 4.1.). Another approach is to model futures prices separately as a separate stochastic process. Separate modelling of futures prices is based on expectations of future movements in electricity prices on the spot market. It can be modelled by a Brownian motion with a given volatility and drift or with a stochastic volatility.

Options are written on futures contracts, and their premium depends on characteristics and prices of futures contracts. On EEX exchange, final price at the end of each trading day is determined by the Black 1976 formula (Fischer Black). Black 1976 is the formula for

calculating value of an option from price movements of a futures contract, while the Black- Scholes formula uses prices from spot market as the underlying asset.

4.2.1. Modelling futures contracts

For modelling futures prices one should consider future/expected prices on the spot market using the current price on the spot market. Futures contract price ( ) for delivery during one day in the future can be expressed as [14]:

Where:

(

)

(

)

(

)

(4.47)

( ) electricity spot price at time t

risk-free rate (represents money that would be obtained if the money is put in a bank instead of buying a futures contract)

T beginning of delivery period

Previous relation is based on no-arbitrage principle and is applicable only in financial markets, while in commodity markets cost of storage - c needs to be added (Cost of carry), as well as the privilege of holding goods - y(t). Electricity can not be stored, so only the privilege of holding a futures contract is taken into account to obtain a relation:

(

)

(

)

(

(

))<