Option value of electricity demand response

Abstract

As electricity markets deregulate and energy tariffs increasingly expose customers to commodity price volatility, it is difficult for energy consumers to assess the economic value of investments in technologies that manage electricity demand in response to changing energy prices. The key uncertainties in evaluating the economics of demand–response technologies are the level and volatility of future wholesale energy prices. In this paper, we demonstrate that financial engineering methodologies originally developed for pricing equity and commodity derivatives (e.g., futures, swaps, options) can be used to estimate the value of demand-response technologies. We adapt models used to value energy options and assets to value three common demand–response strategies: load curtailment, load shifting or displacement, and short-term fuel substitution—specifically, distributed generation. These option models represent an improvement to traditional discounted cash flow methods for assessing the relative merits of demand-side technology investments in restructured electricity markets.