Browsing by Author "Hytönen, Juha Ville Samuli"

As electricity markets have been liberalised the role of derivatives in the electricity markets has increased. It is in the interest of market participants to close at least some electricity prices in advance in order to reduce uncertainties in highly volatile electricity markets. Electricity markets are an interest of many different disciplines. In addition to the technology of electricity production, costs and transmission, electricity markets are studied in economics. Operating in free markets requires also the viewpoint of finance for derivatives’ risk management and pricing. The focus of this study is the term structure of electricity futures in the Nordic electricity markets. The term structure is affected by many factors and no conclusive stylized facts or theories have been discovered. There is even mixed evidence on the sign of the risk premium. This thesis discusses the term structure of electricity futures from the theoretical derivatives pricing point of view and from the standpoint of risk premium due to demand and supply in the markets. Electricity is produced in different kind of power plants that have varying cost structure. Some of the plants are suitable for continuous energy production due to small marginal costs of production. Other plants are extra capacity for demand peaks. The marginal production costs in these plants are considerably higher than in the plants used for continuous electricity production, but their fixed costs tend to be much lower. Launching production for a short time period with these plants for a demand peak does not cause unreasonable costs, so they can be used as reserve capacity that is necessary for the transmission grid. The increasing marginal cost of electricity production must be acknowledged when modelling electricity prices. A unique feature in the Nordic energy markets is the large share of hydro power, which exists especially in Norway and Sweden. Hydropower is cheap to produce. When modelling electricity prices, it important to recognize that hydropower can be economically stored as water reservoirs, unlike other electricity. As the Nordic electricity markets keep integrating, the transmission capacity has increased between countries, and the process is continuing to south. The Nordic water reservoirs have a major effect on electricity prices. Risk neutral pricing that is dominant in derivatives pricing is based on the assumption of perfectly hedgeable and liquid markets. Models based on this no arbitrage pricing have been derived for the purposes of term structure of electricity contracts. These models that focus on a single time point cannot be used in practice in the Nordic electricity markets. Instead, futures pricing is based on historical risks and the risk premiums due to supply and demand for electricity contracts. Models predicting the actual electricity price are normally based on bottom-up approach on electricity markets and external factors. The empirical part of this thesis studies the term structure of the electricity futures and especially the term structure of volatility using principal component analysis, a statistical method widely used in the fixed income markets, and a parametric multifactor model that focuses on the unique features of electricity markets. The empirical study sheds light on the seasonality of the electricity prices and the effect of contract maturity on price and volatility. The findings are largely in line with earlier studies and the high explanatory power of the principal component analysis supports its use as part of risk management in the electricity markets. The preliminary calculations preceding the actual empirical models support the important role of water reservoirs on the price formation and show that the prices of electricity futures are higher than the spot price. The latter observation contradicts the classical view on commodity term structure (normal backwardation). This is probably due to the fact that electricity is necessary as commodity and electricity buyers cannot store it, whereas producers have a limited storing capacity due to the dominant role of hydropower in the Nordic region.