How Options Provided by Storage Affect Electricity Prices

28 Pages Posted: 13 Mar 2007

See all articles by Lewis T. Evans

Lewis T. Evans

Victoria University of Wellington - New Zealand Institute for Study of Competition and Regulation Inc. (ISCR)

Graeme Guthrie

Victoria University of Wellington - School of Economics & Finance

Date Written: February 1, 2007

Abstract

Generators supplying electricity markets are subject to volatile input and output prices and uncertain fuel availability (water flows in the case of hydro and gas availability in the case of thermal plants). We show that a price-taking generator will only generate when the output price exceeds its operational marginal cost by an amount that reflects the value of the option to delay the use of stored fuel. We argue that the option value of delaying fuel use, which is an increasing function of spot price volatility and the uncertainty about fuel availability, must be considered when evaluating whether market power is present in electricity markets. We calibrate our model to the California electricity market and show the implications of Hurricane Katrina for the offers of generators in that market. The standard approach adopted to date for simulating electricity supply curves for use in market power evaluations will produce supply curves that are quite different from those that recognize possible fuel availability limitations, even in the complete absence of market power.

Keywords: Storage, Real Options, Electricity, Market Power

JEL Classification: D4, L1, L4

Suggested Citation

Evans, Lewis T. and Guthrie, Graeme, How Options Provided by Storage Affect Electricity Prices (February 1, 2007). Available at SSRN: https://ssrn.com/abstract=960878 or http://dx.doi.org/10.2139/ssrn.960878

Lewis T. Evans (Contact Author)

Victoria University of Wellington - New Zealand Institute for Study of Competition and Regulation Inc. (ISCR) ( email )

Wellington 6001
New Zealand
64 4 4635562 (Phone)
64 4 4635566 (Fax)

Graeme Guthrie

Victoria University of Wellington - School of Economics & Finance ( email )

P.O. Box 600
Wellington 6140
New Zealand
64 4 463 5763 (Phone)

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