A Structural Model for Electricity Prices

In this paper we propose a new and highly tractable structural approach to spot price modeling and derivative pricing in electricity markets, thus extending the growing branch of literature which describes power price dynamics via its primary supply and demand factors. Using a bid stack approach, our model translates the demand for power and the prices of fuels, used in the power generation process, into spot prices for electricity. We capture both the heavy-tailed nature of spot prices and the complex dependence structure between power and its underlying factors (fuel prices and demand), while retaining simple and commonly used assumptions on the distributions of these factors. Moreover, the derived spot price process then leads to closed form formulae for forward contracts on electricity and for dark and spark spread options, which are widely used for the valuation of power plants. As the stack structure and merit order dynamics are embedded into the model and fuel forward prices are inputs into the formulae, we capture a much richer and more realistic dependence structure than can be achieved through classical reduced-form price models. We illustrate this advantage through several comparisons with other common models for spread option pricing such as Margrabe’s formula and a simple cointegration approach to power and fuels.