Effects of Option Contracts on Electricity Markets: A Cournot Equilibrium Analysis

Abstract

Option contracts have been widely applied in electricity markets for their advantages of flexibility and diversity. While risk management using option contracts has been extensively investigated, impacts of these option contracts on generation companies' (Gencos') strategic bidding behaviors and the market equilibrium outcomes have not been well understood. For this purpose, this paper addresses the electricity market equilibrium problem when Gencos sell financial call options or buy financial put options. A Cournot equilibrium model for electricity wholesale market competition is developed taking into account Gencos' option contracts and the forced outages of generation units. The uncertainty in load demand is also considered to reflect option contracts' advantages of flexibility. The introduction of option contracts and generation unit outages leads to a non-smooth and complicated equilibrium problem. An iterative solution method is employed to solve this equilibrium problem. Numerical examples show that call options with relatively low strike prices or put options with relatively high strike prices will help to reduce Gencos' interests to raise market price by strategic behaviors, thus mitigate their market power abuse in electricity markets.