Managing Energy Risk: An Integrated View on Power and Other Energy Markets

2

Energy Derivatives

An energy derivative is a contract that is derived from an underlying energy related commodity. Such a contract may be an agreement to trade a commodity at some future date or to exchange cash flows based on energy prices at future dates. A basic classification of energy derivatives is given in Figure 2.1. We first distinguish between options and contracts without optionality, such as forwards, futures or swaps. Options in energy markets have a long history. Before the formation of liberalised energy markets optionality was needed to react to fluctuations in consumption, interruptions in transmissions or power plant outages. Power plants or gas storage facilities provided flexibility that was historically used to balance the system load but is presently being used to optimise the profit against market prices (see section 4.2). Many options on a daily or hourly basis can be seen as an abstract model of a certain type of power plant, also referred to as a virtual power plant.

Figure 2.1 Overview on energy derivatives

Besides describing different types of energy derivatives this chapter introduces methods to determine their fair value. The fair value of a contract is defined as the price for which a neutral market participant would be willing to buy or sell the contract. When deriving fair values, we make the general assumption that the market is arbitrage free, ...