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Simulating Electricity Prices: negative prices and auto-correlation

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If you have a question about this talk, please contact Dr Vivien Gruar.

BP Supply & Trading has a significant power trading business in North America and is seeking to build a similar commercial activity in continental Europe. Much of this new business will be customer focussed, with a strong emphasis on providing tailored commercial solutions to physical market participants, ranging from vanilla instruments to more complex structures, for example spark-spread options, swing contracts and virtual power plants. The generally non-storable nature of electricity imposes considerable valuation challenges from a derivatives pricing perspective. For example, the increase in renewables use lead to the apparition of negative spot prices. As the electricity production of renewable (wind or solar) is hard to predict, the supply on the grid is exceeding the demand by a large amount. Consequently, the settlement price of power becomes negative to incentivise non-renewable (e.g. gas or coal) generators to switch off. Price models such as the log-normal Black-Scholes model do not consider these stylised facts and need to be extended for commodity markets.

Another feature of commodity markets is that the price dynamics of power is heavily dependent on the dynamics of that of fuels used for its production, especially gas. This dependence has recently been modelled in the context of co-integration which assumes the existence of a long term stationary process that drives both the power and gas prices. In the short term, the power and gas prices can diverge but they ultimately converge to their long-term equilibrium.

This research project will explore recent modelling approach that have been put forward to model negative power prices and/or the combined dynamics of power and gas. Both are very active research topic for BP Supply & Trading. First, power derivatives will be significantly affected by the presence of negative prices. Second, traditional modelling of the joint dynamics of power and gas through a correlation coefficient leads to overestimating the value of a price generation assets. The use of co-integration is paramount to price correctly these.

References
  1. Benth, Fred & Koekebakker, Steen. (2015). Pricing of forwards and other Derivatives in cointegrated commodity markets. Energy Economics
  2. Enzo Fanone, Andrea Gamba, Marcel Prokopczuk, The case of negative day-ahead electricity prices, Energy Economics, Volume 35, 2013, Pages 22-34

This talk is part of the Cambridge Mathematics Placements Seminars series.

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