Arbitrage Pricing and the Temporal Relationship of Electricity Prices

Abstract

The key issue in relating electricity spot and forward prices is storability. The lack of economic storage opportunities for electricity makes it impossible to form a cash and carry type arbitrage portfolio. As a result we cannot impose any arbitrage free bounds on the relative levels of spot and forward prices. It does not end there however. There is no limit on how far the prices of two forward contracts with different delivery months can diverge, since no arbitrage portfolio can be created to exploit the price differential. The story gets worse when we address the spot market. For a given year there are 8760 delivery hours, each with a unique price. There is no constraint on the relative price of spot power from one hour to the next. Relying purely on arbitrage theory, the number of random variables needed to define the spot and forward markets for one year would therefore be 8772. To use the forward market with a hedge we would need to estimate the entries into the 8772 by 8772 covariance matrix. Electricity markets suffer from a severe case of the curse of dimensionality. To circumvent this problem we must rely on effective modeling solutions. In the next chapter a detailed model for the spot market will be presented, describing the temporal correlation of prices as a function of fundamental drives. Before going through this process, however, we examine the relationship governing the spot and forward markets in the context of non-storability.