Valuation of Electricity Futures: Reduced-Form vs. Dynamic Equilibrium Models

Abstract

Equilibrium and reduced-form models are partly competing, partly complementary approaches to value electricity futures. We present the first empirical comparison of a one-factor reduced-form model and a demand driven dynamic equilibrium model. The contribution to the literature is twofold. First, on the theoretical side we develop a dynamic generalization of the static model by Bessembinder and Lemmon. As a result we endogenously derive the term structure of futures prices and risk premia. Second, on the empirical side we test both models using price data from Nord Pool. Our main findings are as follows. (1) The equilibrium model is able to explain the increasing volatility and right-skewness of futures prices for a decreasing time to maturity. (2) The cost function in the equilibrium model has to be parameterized by the water reservoir level to obtain reasonable spot and futures prices. (3) The equilibrium model provides better out-of-sample estimates of futures prices than the reduced-form model, and it is able to capture price peaks.

Keywords: Electricity Futures, Risk Premium, Reduced-form Models, Equilibrium Models

JEL Classification: G13