Development of a Hybrid Model for Electrical Power Spot Prices

Abstract

In recent years a great deal of interest has been paid to the market-based pricing of electrical power. Electrical power contracts often contain embedded options, the valuations of which require a stochastic model for electricity prices. Successful stochastic models exist for modeling price variations in traditional commodities. Electricity is critically different from these commodities as it is difficult to store and, on short time scales, its price is highly inelastic. This has important implications for stochastic spot price models of electricity. Several stochastic models of electricity spot prices already exist. In these random models price retums play a dominant role. In this paper we lead a guided tour through existing electricity price data to motivate a new stochastic electricity price model that is different in that it directly models price. We apply the new model to the problem of pricing options on electrical power and discuss these preliminary results.