An Analytical Model for Standard and Volumetric Cap and Floor Pricing in Electricity Markets

Abstract

In this paper we derive the term structure of the implied volatility of an electricity 'cap' contract. We leverage earlier work where we derived analytical representations for stochastic demand and deterministic price.We first demonstrate that we can back-out implied volatility at all points of embedded optionality within the cap using the market cap futures price and the expected price curve (in turn derived from a state demand forecast).We next demonstrate that a cap priced with such a term structure of volatility will return the quoted price, and show the price evolution of the cap based on alternate strike prices (for which futures contracts are not available).Next we turn to a floor contract struck on demand (or output) rather than price. We derive the model for this option, based on the volatility of the underlying demand curve, and price a volumetric floor on state demand. We then describe how such a model could be used as a hedge instrument for an intermittent generator such as a solar or wind farm.