Constrained Capacity and Equilibrium Forward Premia in Electricity Markets
45 Pages Posted: 8 Aug 2006 Last revised: 21 Nov 2007
Date Written: October 18, 2007
Abstract
This paper extends the equilibrium electricity pricing model in Bessembinder and Lemmon (2002). The new model accounts for constrained capacity, an important feature in electricity markets. Explicitly including a role for capacity allows the model to reproduce the price spikes observed in wholesale electricity markets using reasonable parameter values. The model implies that the equilibrium forward premium, defined to be the forward price minus the expected spot price, is decreasing in spot price variance when the expected spot price is low, but is increasing in the spot price variance when the expected spot price is high. I extend the empirical work in Longstaff and Wang (2004) and show that data from the Pennsylvania-New Jersey-Maryland (PJM) market support these model predictions.
Keywords: forward risk premium,forward pricing, nonstorable commodities
JEL Classification: G0, D4
Suggested Citation: Suggested Citation
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