A Multi-Fuel Structural Model for the Electricity Market Applied to CHP Generation

Abstract

This paper presents an analytical structural model for the electricity price process driven by stochastic load as well as stochastic marginal generation costs in a multi-fuel stack framework covering the entire fuel switch dynamics. Moreover, the random character of available generation capacity in the merit order is included. The embedded random variables for load and fuels are presumed to be normally distributed. We present closed-form expressions for the forward curve as well as for European contingent claims written on electricity for the general case of N fuels embedded in the power supply stack (esp. for N>2). Additionally, we compile a useful collection of analytical formulas for probabilities and transition probabilities. The structural model is applied to a combined heat and power (CHP) generation unit. On the back of different fictitious market scenarios for a five fuel generation stack, the expected revenues for the two CHP operation modes -- the heat driven as well as the power driven dispatch -- are explored.

Keywords: Structural model, fuel switch, electricity price process, stochastic process, power options, merit order, supply stack, price spikes, forward curve model, CHP plant, combined heat and power, cogeneration, electricity plant evaluation

JEL Classification: C61, D21, G13, L94, Q40