UNIVERSITY OF SPLIT

FACULTY OF ELECTRICAL ENGINEERING,

MECHANICAL ENGINEERING AND NAVAL
ARCHITECTURE




MASTER THESIS



MODELLING ELECTRICITY SPOT
AND FUTURES PRICE





Boris ikoti




Split, September 2014.



















UNIVERSITY OF S PLI T
FACULTY OF ELECTRICAL ENGINEERING,
MECHANICAL ENGINEERING AND NAVAL ARCHITECTURE
Field of study: Electrical Engineering
Study programme: Power systems
Programme number: 232
Academic year: 2013./2014.
Name and surname: Boris ikoti
Student number: 639-2012
THESIS ASSIGNMENT
Headline: MODELLING ELECTRICITY SPOT AND FUTURES PRICE
Assignment: Describe various models, market structures and functionality of power
exchanges using several exchanges in Europe as a reference. It is also
necessary to describe the derivatives market and the manner of functioning of
market products such as options and futures contracts. Single out one exchange
in Europe and make a detailed description and conduct a basic statistical
analysis of prices in last 10 years. Conduct spot price simulations using
simplified stochastic processes and illustrate a basic protection against risk
using futures contracts.

Application date: 03. March 2014.
Thesis submission deadline: 15. September 2014.
Thesis submission: 01. September 2014.

President
Thesis defence committee Mentor:
Associate professor, Goran Petrovi, Ph.D. Associate professor, Ranko Goi, Ph.D.
TABLE OF CONTENTS
1. INTRODUCTION ............................................................................................................. 1
2. ELECTRICITY MARKET LIBERALIZATION ......................................................... 2
2.1. Liberalisation process .................................................................................................. 3
2.2. Conditions for reform ................................................................................................ 10
2.3. Measures of liberalisation and deregulation .............................................................. 13
3. ELECTRICITY MARKETS ......................................................................................... 15
3.1. Market Structures for electricity ................................................................................ 16
3.1.1. Pool model .......................................................................................................... 17
3.1.2. Power exchange ................................................................................................. 18
3.2. European power exchanges ....................................................................................... 23
3.3. European Energy Exchange EEX ........................................................................... 27
3.4. Spot market ................................................................................................................ 29
3.5. Derivatives market ..................................................................................................... 48
3.5.1. Futures contracts ................................................................................................ 49
3.5.2. Forward contracts .............................................................................................. 57
3.5.3. Option contracts ................................................................................................. 57
4. MARKET SIMULATION MODELS ........................................................................... 62
4.1. Stochastic spot price modelling ................................................................................. 63
4.1.1. Basic statistical analysis .................................................................................... 66
4.1.2. Brownian motion ................................................................................................ 70
4.1.3. Parameter estimation ......................................................................................... 73
4.1.4. Mean reverting processes ................................................................................... 76
4.1.5. Jump diffusion processes .................................................................................... 82
4.2. Derivatives modelling ................................................................................................ 84
4.2.1. Modelling futures contracts ............................................................................... 85
4.2.2. Modelling options ............................................................................................... 90
4.2.3. Economic application of simulation models ...................................................... 98
5. CONCLUSION ............................................................................................................. 107
REFERENCES ..................................................................................................................... 109
SUMMARY ........................................................................................................................... 110
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1. INTRODUCTION
The electricity industry has undergone big structural changes over the last two decades.
Traditionally, electricity companies were regulated or state-owned monopolies governing the
generation, transmission, distribution and retail of electricity. In this regulated setting, power
prices changed rarely and did so in a deterministic way. As a result of this restructuring,
prices are now set by the fundamental powers of supply and demand.
In these new, liberalized electricity markets, national and international parties have joined
the formerly exclusive group of market participants, creating new risks as well as new
opportunities for utility companies, distributors and consumers alike. Electricity wholesale
markets are now the centres of an increasing amount of trading activity in spot contacts
(short-term delivery of electricity). Because of the large price risk involved in trading spot
contracts and the wish to hedge (price) risk in general, other contingent claims such as futures,
forwards and options have been introduced to the electricity market.
Thesis is split into two parts. First part, which includes the second and third chapter, lists
basic steps of electricity markets liberalization process, explains various types of markets,
lists the majority of European power exchanges and explains the structure of spot and
derivatives market. Combining electricity trade of a large part of continental Europe,
European Energy Exchange EEX was used as a referent power exchange.
Second part, which includes the fourth chapter, reviews simulation models used to model
spot prices and explains models used to evaluate the price of futures contracts and option
premiums. Several economic applications of simulation models are mentioned, both for
business analysis and hedging. Historical prices from EEX exchange are used as a reference,
specifically spot and futures prices and option premiums with delivery in Germany/Austria.
During spot price simulations only stochastic processes were analysed. To simulate the
movement of futures prices two distinct approaches were mentioned. One of which is a direct
linking of the futures price with spot price and the other a separate and independent modelling
of the futures price. Options are written on futures contracts and their premiums are
determined by the characteristics and price movements of futures contracts and they were
modelled using a well known Black 76 formula.
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2. ELECTRICITY MARKET LIBERALIZATION
The current reform in the global electricity supply industry (ESI) is often presented as
being a sudden change. Whilst it is certainly true that there are, in any one country, step
changes of rules, regulations, laws and structures, that are commonly associated with a
timetable of deadlines, they are in practice part of a continuum in which major structural
changes took about ten years to agree, and ten years to implement and settle down.
At high level, the reasons for reform are the growing belief, based partly on experiences to
date, that by market orientation, the industry can be more efficient.
Having begun as liberalised free enterprise in the 1880s, and fallen into municipal, federal
hands over the next few decades, the liberalisation experiment began in 1970s with a partial
opening of the generation sector to new entrants from whom the utilities were required to buy,
and continued in the 1980s with the beginning of consumer choice. The 1990s saw the
beginnings of competitive electricity markets with the growth of pool models, and the year
2000 saw the first bilateral physical market with the New Electricity Trading Arrangements
(NETA) in England and Wales.
Change was then rapid with the proliferation of market opening and power exchanges
across the world, and development of the market models for capacity, location and
environmental factors.
The journey has been broadly consistent in most countries and has been characterised by
many elements, such as reform, liberalisation, deregulation, re-regulation, third party access,
privatisation and unbundling. Many of these elements are now complete in many countries
and at this point, the countries are considering the virtues and drawbacks of the new model,
and in some places taking the market model to new levels of technical complexity.
The challenge has been to open the market to competition in a measured and controlled
manner such that each stage can be viewed in retrospect with regard to intended and
unintended impacts. In doing so, there is the recognition that networks have a strong tendency
to being natural monopolies, and hence that liberalisation and deregulation must begin with
power generation and supply.
If there is common ownership of networks and generation, or networks and supply, or both
(as there is in a national monopoly), there is conflict of interest, so that the incumbent is
incentivised to raise the entry barrier and excessively charge the new entrants. Hence, new
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entrants need to be guaranteed free and fair access to power generation or consumption. This
is by no means simple, even with the best will of the incumbents because the operation of
power generation and of the transmission grid is optimised as a single entity.
Hence to allow competition, it is first necessary to restructure the national monopolies into
vertically de-integrated (unbundled) form, and for there to be some form of commercial
arrangement between the unbundled tiers so that this arrangement can be followed by the new
entrants.
There are essentially three components to liberalisation in the ESI:
Reduction of the role of the state, in terms of ownership, command and control,
prescriptive solutions and direct cross subsidy.
Creation and enhancement of competition by deregulation, vertical de-integration
(unbundling), horizontal de-integration (divestment) and regulated third party access.
Increasing choice for consumers and participation in short and long term demand
management and responsibility to secure their energy.
From an industry perspective, some liberalisation objectives are:
Introduce competition in generation.
Introduce customer choice.
Deal with independent power producer and stranded cost issues.
Attract private investment.
Entrench universal service obligations.
Promote integration of the grid.
Reduce debt.
2.1. Liberalisation process
We have noted that the ESI is highly complex due to the special nature of electricity and
that there is a very wide variation in key factors such as energy endowment and social model.
There is no one size fits all, and since no policy maker can unilaterally impose a new model
and design by committee is difficult.
Therefore the ESI takes incremental steps. This is shown in Figure 2-1.
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Figure 2-1. Planning small changes in a complex market [1]
Most countries are undertaking liberalisation in some form, and the starting point, pace and
scope varies in each country. There are several steps. The list below is in approximate order,
but this has been different in different places.
Corporatisation.
Unbundling.
Ring fence chosen sectors. For example, nuclear, hydro, grid;
Privatisation.
Forced divestment and fragmentation of incumbent utilities.
Deregulate.
Reregulate.
Further fragmentation.
Further unbundling and opening to competition.
Re-integration of some sectors and cross sector integration.
Re-consolidation
Horizontal integration with other industries.
Entry of financial institutions into the wholesale markets.
Pressure on retail deregulation.
Further deregulation of networks and metering.
Revise model.
5

Unbundling is one of the foundations of ESI reform. It is the separation of the vertically
integrated industry sectors in such as manner as to facilitate competitive and non
discriminatory access of participants to means of operation and route to market for the
products or services. At the highest level, the industry divides neatly into the four sectors:
generation, high voltage transmission, low voltage distribution and supply.

Figure 2-2. The unbundled ESI model, showing the four main industry sectors [1]
It is clear, for example, that if a generator wishes to access the consumer market that
without unbundling, a vertically integrated participant could easily deny access to the delivery
of electricity.
There are different degrees of separation in the unbundling processes that should be
considered as stages.
Functional separation This involves the separation of the day to day business and
operation of the divisions. Whilst resources should be clearly allocated between the
divisions, there is no specific requirement for the inter business arrangements to be on
a commercial basis. For example, one could be a cost centre. However, the path is
clearly laid open for full separation, since cost centres can optimise and prioritise
effectively only if the services provided have clear monetary signals, thereby forcing
the profit motive, a profit centre approach and then standalone businesses.
Operational separation This involves separation of long term decisions, capital
expenditure and operation of the businesses. This is a natural progression from
functional separation, and the natural separation of board level decisions makes the
path for board level separation.
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Accounting separation This involves the formal production of separate accounts for
the different parts of the business. Whilst this requirement may at first sight appear a
relatively straightforward one, involving capital expenditure, depreciation, core
operating budgets and some form of financial arrangement between the respective
divisions, the construction of full statutory accounts for each division actually sets a
clear path for full separation of the businesses since all resources must be accounted
for in one business or other, and all flows of commodity or service from one to another
should be treated as arms length arrangements on commercial terms. In practice,
journey from informal inter business arrangements to formal commercial
arrangements is a long one and hence there are many degrees of accounting
separation.
Legal separation The component companies are completely separate from a legal
perspective, although they could be ultimately owned, in whole or part, by the same
entity.
Ownership separation This means no significant common ownership.
As a general rule, partial unbundling of generation is the first step, by allowing and
encouraging private new entrants. This can be regarded as stepwise deregulation. The next
major step is the separation of the high voltage grid from the other sectors. The unbundling of
supply from distribution is generally a late stage, and gradual deregulation of metering, and
networks at their boundaries and various support services continues after the main unbundling
is complete.
Corporatisation is a necessary precursor to unbundling because the unbundled sectors
cannot operate independently without being corporatized. Corporatisation is the process by
which a publicly owned company with a public service franchise and purpose starts to behave
like an investor owned company. This it self has many elements:
The requirement of each entity not to lose money, with no cross subsidy from one
entity to another. (Pareto optimality, applied within the firm).
Migration of some long term and high level responsibilities back to governments. For
example nuclear decommissioning.
Public service becoming a requirement rather than a purpose.
Preparation for unbundling by internal transfer pricing, and service level agreements.
7

Increased independence from the fiscal and monetary structure of the nation. For
example, payment of taxes, payment for fuel.
End of requirement to create labour.
One of the first stages of corporatisation is by introducing formal arrangements between
the sectors that will be unbundling. This includes payments for goods and services. The
arrangement is shown in Figure 2-3. Each sector has cash inflow and goods and/or service
outflow. Consider initially a centrally managed economy. This is depicted in Figure 2-4. In
the extreme case for a closed economy with no money, then labour and natural resource
replaces the tax required to buy equipment.

Figure 2-3. Formal arrangements between unbundled sectors [1]

Figure 2-4. Arrangement for a centrally planned economy [1]
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Regardless of ownership, the state is the ultimate guarantor of ESI performance.
Accordingly, governments have been reluctant to relinquish control in some areas. The main
three areas are described below.
Nuclear power This has commonly remained under national control because it has
been considered that governments should be able to determine the amount of nuclear
power generation in the future, that nuclear decommissioning funds can only be
assured by public sector retention, that consolidation of nuclear power maximises
safety, and that overall public interest with respect to such a long term issue as nuclear
power can only be served by having national ownership and accountability through the
electorate.
Hydro power The case for public sector retention for existing large hydro plant for
the protection of public ownership of natural resources is not particularly compelling
in countries which have been happy to privatise fuel and mineral extraction. However,
the construction of large dams requires such significant trade offs between national
and local environment that sometimes the public interest can only be best served by
public ownership. The control of hydro dispatch is also highly useful for the system
operator. In addition, international aid, commercial loans and soft loans in relation to
large hydro schemes and the sheer size of the schemes often calls for a high degree of
state involvement.
National grids National grids are commonly retained because it was felt, with some
justification, that the grids form the focal point through which the industry is managed
in the short and long term. By maintaining control of the grid, there was de facto
control on every other sector, and by maintaining control of the grid, it was possible to
form a coordinated view of security of supply, and then facilitation of whatever
construction is required to alleviate this.
When state monopoly is corporatized, vertically unbundled and horizontally fragmented,
then component parts can be privatised, one at a time, or all together.
There are essentially three types of privatisation:
Widely distributed, in which the share price is set low and there is a per capita
allocation to the population.
Public offerings, in which investors (both strategic and institutional) buy the stock.
Trade sale, in which the whole organisation is sold to a single company.
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The privatisation process is a very sensitive one, since the ESI is seen as a national asset
and there is often a risk (perceived or actual) that the stock is sold at low prices to individuals
and companies with political connections.
The regulated sector is comprised of privately owned local monopolies, but has prices,
revenues and/or profits regulated by government through the regulator. Deregulation is the
process by which parts of the regulated sector are opened to competition.
We have seen how the generation sector has generally been open to competition for a long
time, and even when the dominant incumbent generator is regulated, generation competition
is not usually classed as deregulation. Almost always, deregulation begins by a gradual
opening of the supply sector to competition, starting with the very largest consumers, with a
phased opening of the market to smaller and smaller consumers, and eventually residential
consumers.
The deregulation process leads to the existence of two distinct sectors the deregulated
sector which is open to competition, and the regulated sector which has regulated prices or
revenues. Regulation is applied to both sectors, but is more of a monitoring, guiding and
policing role in the deregulated sector than a price setting one. From a regulatory perspective,
the retail sector is the most important sector, since this is the interface between ESI and
consumer.
The presence of financial institutions should be regarded as a measure of success, of
market reform. Financial institutions can enter the industry in a number of ways including
strategic investment, loans, wholesale market trading and electricity supply. There have been
several circumstances in which creditors have acquired the assets of power companies as
collateral on default.
There are a number of measures of success for ESI reform. In the light of these we must
decide: if there has been sufficient market reform to achieve success and if the market has
reformed substantially, then how should we adjust the model to improve ESI performance in
delivering welfare, how to deliver further economic and environmental efficiency.
There are a number of areas to examine, including::
Prices what has been the effect of reform on prices, and what can be done?
Consolidation how much is too much?
Demand management will market mechanisms eventually deliver this, or must a
prescriptive solution be applied?
10

Data is the electricity meter flow data structure robust enough to recover from errors
and to handle events such as change of supplier, occupier, or meter?
Metering to facilitate demand management, should parts of the metering sector be
regulated or deregulated?
The macroeconomy how much do increasing prices resulting from environmental
limitations affect the economy?
The environment taxing externalities, or command and control.
Security of Supply assignation of responsibility or mechanisms for security of
supply.
Universal service.
Cross subsidy.
2.2. Conditions for reform
Early stage reform, such as corporatisation, and high level administrative unbundling,
provides quite different challenges to late stage reform, such as exposing elements of
transportation to competition and the development of wholesale derivative markets. To enter
each stage of reform, there are prerequisites in terms of will and capability.
Generation capacity The implementation model depends greatly on the current
generation capacity in relation to demand. If capacity is insufficient, then priority is
fair market access rather than competition in generation. If capacity is excessive, then
the divestment of ownership must provide current stability (possibly including vesting
arrangements for stranded assets), both for the dominant incumbent and the new
players, as well as a road map for both retirement and new build.
Investment environment This is enhanced by stability of laws and taxes, mature
local financial markets, freely traded currency, absence of hyperinflation and low
country risk.
Rationalised cross subsidies The cost of low consumer prices arising from industry
subsidy must be recovered by taxes, either from the subsidised consumers, or other
consumers. In this circumstance, new entrance is not possible, and the cross subsidy
system has to gradually unravelled.
The will to disaggregate the ESI from the national economy to some degree. The ESI
can be a haven for employment in both the ESI and in the fuel sector.
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A high voltage grid that is sufficiently present and reliable.
The ability to collect tariffs for electricity, supported by the laws, police and courts,
property access rights and disconnection rights.
Supportable universal service requirements.
Even in a fully privatised industry, the ESI is a collection of assets, existing property
rights, right to build, franchises and obligations that has an inbuilt legacy relationship between
private and public sectors that is de facto and informal as much as it is formal. These
relationships built up incrementally as the industry developed, with a few step changes such
as nationalisation and deregulation that in fact made relatively slight differences to this
collection. The state therefore retains an intimate connection with the running of the ESI.
The state is the ultimate guarantor even if companies in the industry fail. In developed
economies, this is particularly important in the consideration of security of supply. The state
has a remit to monitor the current and likely achievement of national and international policy
objectives that are affected by the ESI, and to intervene where the delivery falls short or can
be enhanced.
Electrification (connection of the population to the electrical infrastructure) is seen as an
essential development for welfare and economic growth. In the absence of a complete market
for emissions or equivalent, the state must manage aggregate welfare by economic or
prescriptive instruments.
The state performs numerous roles, for example:
The participation of the ESI in the fiscal structure of the macroeconomy.
The setting of policy.
Primary legislation (Acts of Parliament) to drive and control policy.
The conversion of direct taxes to indirect taxes..
The management of those parts of the ESI that remain under state control.
Consumer subsidy if the requirement for cross subsidy within the ESI is reduced.
Corporate cross subsidy by taxation and concessions.
Prices are not the only measure of the success of liberalisation, and that prices are but one
outcome of political model and industry structure. We can see in Figure 2-5. that there can be
a wide variety of electricity prices, depending on the degree of state subsidy, which itself is
dependent on the tax revenue (and welfare saving if unemployment is reduced) from the ESI.
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Indeed either the fully managed model or the open market model can in theory achieve low
prices when pursued to its logical conclusion.

Figure 2-5. The role of the ESI in the fiscal structure of the macroeconomy [1]
Regardless of ownership, the government has ultimate right of control. To the industry this
represents a moral hazard as well as a potential lifeline for ailing companies as well as
protection for consumers. The government is the de facto ultimate guarantor of the industry
performance in terms of the delivery of electricity to consumers.
Governments can and do retain substantial influence of nationalised and other private
companies. Such mechanisms include:
Shares Full or partial ownership, golden shares (a share with significant voting rights
but no significant economic value).
Legislation Primary legislation (Acts of Parliament), secondary legislation (the
detailed drafting of the Acts).
Taxes New taxes, windfall taxes, change in tax rates, tax breaks, categorisation of
tax liability.
Licences Generally determined by legislation, moratoria, as soft mechanisms such
as slowing down the on going series of permissions.
Rules and regulations.
Arbitrating and determining On disputes between different parties, and on
interpretation of laws and regulations.
Administration Slowing the operation of the company by means of enquiry and
general administration.
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Retained ownership Of key sectors.
Discretionary enforcement of laws and regulations, and implicit connection between
ESI implementation of one policy and enforcement of a completely separate law or
regulation.
2.3. Measures of liberalisation and deregulation
Since liberalisation and deregulation is a global experiment, it is natural to wish to
compare the experiences across the world. There are many comparative indicators, some of
which are listed here.
Declared level of opening percentage market openness, pace of opening, import-
export extent, presence of international commercial agreements.
The planned year of full market opening.
Price level of transmission network usage separate tariffs for energy and transport,
within the country and with neighbouring countries.
The way the transmission network is allocated.
o Separated by ownership from other ESI sectors.
o Legally separated as a separate entity in which other participants in the ESI
may have a part ownership.
o Separated at the management level from other ESI sectors.
The way the market is regulated.
o Regulated third party access, controlled by an independent regulatory body.
o Negotiated third party access
The existence of the Balancing market.
The market share of the biggest / largest manufacturers.
European Commission Directorate General, Transport and Energy Energy
liberalisation indicators in Europe (2001) This considers the regulated and deregulated
sectors separately. In the deregulated sectors it considers matters such as development of
competition and development of the wholesale markets. In the regulated sectors it considers
matters such as access and interconnectivity of networks.
EU benchmarking studies These are published specifically in relation to the EU
Directives, but are quite general in nature, and include non EU countries such as Norway. The
first, second and third benchmarking reports were produced in 2001, 2003 and 2004, and
14

focus on matters such as liberalisation timetables, roles of regulators, market monitoring,
network access and tariffs, as well as other issues such as treatment of congestion,
transmission investment, interconnection, cross border tariffs and balancing services.
Centre for the advancements of energy markets (CAEM) Retail Energy Deregulation
Indicator (2001) This considers specifically the retail sector. It has 22 criteria, each with a
score of 1 to 100. Examples are:
Is there a detailed plan for customer choice?
How many customers can currently make a choice and how many have switched to
competitive suppliers?
Are there standard business practices and is competition in metering and billing
allowed?
Is generation deregulated and is there a vibrant wholesale market?
How are customers integrated into the programme? Are they informed about their
options? Is customer information disseminated to promote competition? Are
customers encouraged to shop in the competitive market?
Are utilities encouraged to offer new services and to cut costs for the transportation
services they provide?
Has the state commission adopted internal reforms to accommodate their new
responsibilities?
There are also a number of studies by consulting organisations, academic institutions and
international bodies, and best practice guides.








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3. ELECTRICITY MARKETS
In economic terms, electricity is a commodity that can be bought, sold and traded. The
electricity market is a system in which prices are formed from the best offers to buy or sell.
Lowest offer for sale is the most favourable offer to buy (Ask price), and the highest offer to
purchase is the most suitable offer to sell (Bid price). The difference between ask and bid
price is called the spread in which the average price for a traded asset class is always located,
as a middle ground between bid and ask. Large spreads indicate high transactions cost, low
liquidity or an increased volatility. What makes electricity market different from other
markets are additional characteristics and parameters related to each MWh (or MW) of
electricity traded on the exchange.
The most important characteristic of electricity is that it can not be efficiently stored and it
can not be stored in large quantities. Consumption and production of electricity has to be
balanced at all times to avoid sudden changes in power network frequency, which would have
disastrous consequences.
Electricity market requires a place and a market operator where transactions are executed,
and offers to buy and sell electricity may be submitted. Market operator provides a trading
platform on which a market participant may trade on the exchange, and supporting financial,
human and material resources required to perform transactions on the exchange. All offers
and transactions on the exchange must be submitted to brokerage firms which pass them on to
the exchange. Brokers take a commission on each trade and competition arises in this segment
of the business as well, making commissions consequently lower.
Electricity is primarily traded on the spot market for a defined delivery period in so called
blocks of electricity. Most of the trade is done for a delivery period of one hour. Spot market
trading is conducted on day-ahead auctions and intraday market. Electricity indices are using
average prices from the spot market as the underlying price.
Along with spot market there is also a power derivatives market of futures contracts and
options. Futures contracts are traded as a 1 MW of Power that will be delivered during a
defined period of delivery in the future. Delivery periods can be from one day to one year.
Options are traded as the right to buy/sell a futures contract at a given price before expiry of
the option.
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Currently leading power exchange in Europe EEX (European Energy Exchange) combines
trade for delivery of electricity to large part of continental Europe. Market operator is a
private company EEX AG. With electricity other commodities and asset classes are traded as
well, such as: power derivatives, guarantees of origin, natural gas (spot and futures market),
emissions allowances and coal.
3.1. Market Structures for electricity
At the beginning of electricity market liberalization, previously monopolistic model is
transformed in order to achieve a wholesale market at first and later a complete power
exchange market. In order to reach a wholesale model, market is usually transformed into a
single buyer model, and the retention period on this simple model depends on many factors
within the country where the market is transformed. Single buyer model is characterised by
the fact that producers only have one buyer to whom they can sell. This model is a natural
step in the liberalization process, before moving to a wholesale model.
Basic characteristics of a wholesale model can be summarized as follows:
Partially open market with a limited number of consumers, defined mostly by
the size of annual consumption, while other consumers are in the public service,
that is, they are supplied by one supplier provider of public service.
Manufacturers independently contract delivery method and price of electricity to
eligible consumers. Small consumers are supplied by the tariff system defined
and approved by an independent regulatory body.
Transition to a wholesale model requires significant transition costs and and
additional costs of administration access to and use of the transmission and
distribution network.
Electricity price of risk (production cost, market price) are transferred mainly to
producers and consumers, as opposed to a non-market system where risk is
exclusively on consumers.
In relation to monopoly system, wholesale model reduces political influence,
though not entirely. The basic premise for this is certainly a well-defined legal
framework and technical regulation of electricity market.
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Wholesale model is always a precursor model of the open market (retail
competition) in which all consumers are allowed to have a free choice of their
electricity supplier.
Basic versions of the wholesale model, based on how the electricity market is organised,
are bilateral model, pool model, and their various blends. In purely bilateral electricity market
it is assumed that market mechanisms, based on bilateral agreements between manufacturers
and trading companies, will lead to real market prices of electricity.
In all liberalized markets of Europe the goal is to achieve a fully liberalised power
exchange. The exception is the United Kingdom (England and Wales) where market is
dominated by a pool model. The following chapter explains the pool market model, while in
section 3.1.2. focus is on power exchanges, showing the way how the market develops to a
exchange model and comparing it with previous market models.
3.1.1. Pool model
In the pool model all producers submit their offer stacks into the pool, which produces
stacks and then sends dispatch instructions. The pool itself is purely an administrative entity
and takes no risks. The basic variants of a pool model are:
Mandatory pool, generation is only allowed through the pool.
Voluntary pool, generators can participate in the pool, or the buyer and seller can
request dispatch to meet a bilateral contract between them.
Pool system has been accepted by most Anglo-Saxon countries, predominant is the second
option (voluntary pool). Mandatory pool poses many questions over the years related to
market efficiency. In the UK (England and Wales) mandatory pool was in the 90s regularly
referred as an exemplary example of an organised electricity market. It was abolished and a
new system based on the model of a bilateral market was introduced NETA (New
Electricity Trading Arrangements).
Protection from variations in market prices is realized through short-term and long-term
financial bilateral contracts (futures and forward contracts), but usually based on CFD
principle ("Contract for difference").
A contract for difference (CFD) is a financial transaction between two parties who do not
necessarily have anything to do with the ESI. There is no explicit connection between the
CFD market and the system operator, and there is generally no market operator. With no
18

explicit connection to the market, the system operator is not obliged to making changes to the
index, and this gives basis risk to CFD participants. The transaction is in the form of a fixed
for floating swap which are common in the financial markets. The transaction is as shown in
Figure 3-1. The price F is fixed, whereas the price PPP is floating until the agreed
indexation date is reached. This can be understood by regarding the swap as two separate
energy contracts. One is the sale of physical energy at a fixed price and the other is a purchase
of physical energy at a floating price.

Figure 3-1. CFD as two separate energy contracts. Q is the energy volume in MWh
The usefulness for generators and consumers/suppliers is shown in Figure 3-2. The
generator A, if dispatched, receives the PPP from the system operator, and this serves as an
index. Supplier B pays an uplift on PPP to pay for transmission, distribution and other
services. The net result is that B always pays a net price of Q (F+uplift) and hence retains no
risk to PPP. The risk to change in uplift is called basis risk. A, if dispatched, receives a
revenue of Q F and hence is insulated from changes to PPP, provided that PPP exceeds the
offer price into the pool.

Figure 3-2. The net result of participation in the pool and transaction of a CFD
3.1.2. Power exchange
We have noted that with the exception of the change from bundled centrally managed
(effectively a communist model) to unbundled centrally managed, that each structural step in
the development of the ESI market is relatively slight. The growth of power exchanges is the
slightest of all, but finally bridges the gap between electricity is a intractably complex product
19

for true competitive wholesale trading, to markets tradable by financial counterparties such as
commodity traders, funds, investment banks and actively hedging consumers.
Since not only do definitions of entities vary widely from country to country but from
model to model we use stylised definitions for the purpose of these figures:
MO Market operator. Financial reconciliation only;
SB Single Buyer. Economic optimiser;
SO System Operator. Managing the physical system from a starting point of physical
notifications;
PX Power Exchange Introducing agent, financial clearing house, physical
notification agent;
PN Physical notification Agreed volume submitted to system operator.
In the simplest pool with no demand side participation, Generators submit offer stacks to
SB, who constructs a trial schedule using consumption history and submits this to SO, which
then manages the imbalance with positive and negative reserve and capacity contracts. A
financial power exchange, not integrated with the MO, can operate effectively for contracts
for difference in this environment since there is an effective market index. In the absence of
the pool index the non integrated PX is vulnerable to index basis, definition, change of
definition and illiquidity.

Figure 3-3. Pool. No demand side participation [1]
With the addition of mandatory demand side participation (no bid no energy), SB no longer
estimates demand. Commercial mechanisms for demand imbalance are required. Figure 3-4.
20



Figure 3-4. Pool model with mandatory demand side participation [1]
In the bilateral model, participants trade with each other instead of the single buyer. Since
the bilateral contract is effectively a PN promise, then reconciliation is required with the
market operator.

Figure 3-5. Bilateral mechanism [1]
The simplest power exchange is simply an introducing function between participants. This
part can be played by brokerage companies which need not have more resource than one
person with one telephone.
21


Figure 3-6. Power exchange, just acting as a broker [1]
A formal power exchange (the standard interpretation of the term), acts as counterparty,
and must therefore reconcile trades.

Figure 3-7. Power exchange, acting as financial counterparty [1]
An integrated power exchange (the most advanced model, figure 3-8.) submits
notifications in relation to the net position from trades executed. If bilateral trades (not shown
below) are required to be posted or crossed on the exchange, then the exchange is very
similar to the single buyer but is driven to reflect market conditions rather than proprietary
estimates. In France for example, bilateral trades are submitted directly to SO (RTE, an
administrative division of Electricit de France) and trades with Powernext are submitted to
SO by Powernext.
22


Figure 3-8. Power exchange, integrated with system operation [1]
The basic commodity is the same in all cases a hourly (or other period) electricity
notification commitment to the system operator. Power exchanges can differ widely in their
details:
Counterparty visibility Whilst it is technically possible for counterparties to identify
each other in some exchange models, the standard arrangement is that contracts are
anonymous.
Auction mechanism The exchanges generally hold an array of bids and offers from
participants, that form the production and demand stacks. This can be published in full
(with anonymity) or just the most recent trade, the highest bid and the lowest offer.
Credit arrangements The exchange requires capital to maintain a very high credit
rating, which is generally (but need not necessarily be) provided by participants.
Trades also require initial margin and variation margin. Margin requires complex
algorithms for electricity.
Licence restrictions An exchange may be limited by rules beyond the exchange. For
example, while a generation or supply license may not be required, registration with a
financial regulator may be.
Location Liquidity is concentrated by trading at exchange hubs. Clearly, pricing is of
postage stamp form within a hub. Exchanges can trade several locations at the same
time, including locations in neighbouring markets.
Live trading or day ahead Whilst exchanges are best suited for live trading, they can
operate in batch mode in a pool-like manner. This is essentially a pool model with
23

demand side participation. Since pool markets produce high quality indexes (i.e. with
high concentration of indices), then the index is amenable for exchange traded
financial contracts for difference.
Index construction and publication Indexes can be published and could be for
example, the closing trade, a weighted average of trades near the close, an average of
unaccepted bids and offers, etc.
Financial derivative contracts For example European options cashed out against the
index, average rate options, multi-commodity options, time spread options
3.2. European power exchanges
The European Energy Exchange EEX is an electronic exchange based in Leipzig, for
trading electricity and related products. Since its inception in 2002, EEX has evolved from a
local to the current leading European power exchange. It is made up of several companies that
establish international partnerships and thus a wider network to trade energy products. Market
operator is a private company EEX AG. EEX is analysed in detail in chapter 3.3. (and
chapters 3.4 and 3.5.).

Figure 3-9. Main trading area on EEX [2]
24

Nord Pool market, the electricity market of the Scandinavian and Baltic countries, founded
in 1993, is currently the largest spot market in Europe. Spot Market ("Nord Pool Spot") is
organized through trade on day-ahead and intra-day markets. In 2013, the spot market
recorded a trade of 493 TWh. Of the total electricity consumption of Scandinavian and Baltic
countries, 84% is purchased on the Nord Pool Spot market in 2013. Until recently there was
no derivatives market, but Nord Pool Spot in cooperation with the company "NASDAQ OMX
Commodities" created a market in financial derivatives based on prices from the spot market.

Figure 3-10. Nord Pool market [4]
IPEX (Italian Power Exchange) is the Italian electricity market established in 2004. With
the goal of Italian market liberalization, competition was created in the spot market. The
volume of trade is not nearly as big as on EEX or Nord Pool markets, but it is constantly
growing with a steady increase in market participants.
Powernext is the French electricity exchange, founded in 2001, which offers trading on the
spot market and the derivatives market. Spot market is organized by "EPEX SPOT" and
derivatives markets is organized via the "EEX Power Derivatives." Market operator is a
private company Powernext SA, which shares ownership with EEX AG in EPEX SPOT, and
has a 20% stake in the "EEX Power Derivatives."
25

APX is a transparent electricity market of Great Britain, the Netherlands and Belgium,
which offers trading on the spot market. In cooperation with the European Commission in
2004, APX has launched a triple market coupling connecting the French, Belgian and Dutch
spot market. Market coupling of the specified countries implies joint bids for sale and
purchase on the spot market, taking into account the network transmission capacity of these
countries.

Figure 3-11. APX electricity market [5]
Belpex is the Belgian electricity exchange established in 2006 that offers trading on the
spot market. An important feature of this exchange is associated trade of electricity on a day-
ahead spot market with two neighbouring exchanges, APX Exchange in The Netherlands and
Powernext exchange in France. The correlation between the prices on these exchanges is 90%
which is the highest recorded market coupling of electricity exchanges. Belpex SA, the
operator of Belpex Stock Exchange, is 100 % owned by the APX exchange.
Endex ("European Energy Derivatives Exchange") is the Dutch electricity market
established in 2002 with headquarters in Amsterdam, which offers only trade of futures
26

contracts of electricity. Participants of Endex exchange are manufacturers, distribution
companies, financial institutions, industrial consumers, "hedge" funds, asset managers, etc.
Omie is the operator of the Spanish spot market, and OMEL is the system operator
responsible for the functionality of the network and consumer supply security. Trade of
Spanish futures contracts is lead by Portuguese company MIBEL. An important factor in the
Spanish electricity market is lack of transmission capacity between Iberian Peninsula and the
rest of continental Europe. Market coupling with the Spanish market would not have
satisfactory results until the completion of additional transmission network facilities which
would increase transmission capacity with the rest of Europe.
EXAA is the Austrian electricity market established in 2002. The number of market
participants has increased from the initial 10 to 74 participants from 15 countries. EXAA only
offers trading on the spot market on a daily basis.
PXE (Power Exchange Central Europe) is a power exchange of Czech Republic, Slovakia
and Hungary established in July 2007. PXE offers trading on spot and futures markets.
Trading financial futures is possible only for Czech Republic delivery area.
Towarowa Gieda Energia or Polish Power Exchange POLPX is Poland's Energy Market,
founded in 2000, which offers trading on the spot market and futures market of electricity.
Due to the lack of liquidity in the futures market, futures trading in Poland Stock Exchange
was discontinued in June 2006 and was reinstated in 2008.

Figure 3-12. Average prices for first 17 days of NWE market coupling project [6]
27

With constant strive for connecting the electricity markets, on February 4, 2014, began a
project to connect the north-western European markets - NWE (North-Western European
Price Coupling). The largest four spot markets in Europe: EPEX SPOT, Nord Pool Spot, APX
and Belpex and 13 system operators from France to Finland, successfully launched market
coupling of the day-ahead spot market. Figure 3-12. presents the average realized prices on
the spot market for different areas of delivery, in the period from 5 February to 21 February
2014. With this project Denmark, a country that is located between two largest spot markets
in Europe, achieved the best results, and the lowest price of electricity ( 28.64 for 1 MWh).
3.3. European Energy Exchange EEX
As previously mentioned, the EEX AG is made up of several companies that establish
international partnerships and thus a wider network for trading energy products. Figure 3-13.
shows EEX Group and EEX AG shares in individual companies.
EEX Group


EPEX SPOT SE
50%

EEX Power
Derivatives GmbH

80%
European
Commodity Clearing
AG

98.5%
European Energy Exchange AG EEX AG

EGEX European Gas
Exchange GmbH

100%
Global
Environmental
Exchange GmbH

100%
Cleartrade Exchange
Pte Ltd.

52%
European
Commodity Clearing
Luxembourg
100%

Figure 3-13. EEX group [7]
For trading electricity, the most important three companies are:
EPEX SPOT SE Operator of electricity spot market "EPEX SPOT". Ownership is
divided between companies EEX AG and Powernext SA. There are spot markets for
France, Germany / Austria and Switzerland.
EEX Power Derivatves GmbH Operator of futures market for Germany/Austria
(Phelix Futures), France and Italy, and options market for Phelix futures. Operator of
28

physical futures market for France, Netherlands and Belgium. It is possible to register
a base load futures contract for Switzerland, Spain, Romania and Nord Pool market.
European Commodity Clearing (ECC) AG Banking company owned by EEX AG
that offers execution of all financial and physical transactions on EEX. Guarantees the
payment and delivery of electricity to all market participants. It offers registration of
bilateral agreements on the exchange.

Figure 3-14. EEX trading participants by country [3]
Physical futures contracts at expiry are realized through physical delivery of electricity.
Financial futures contracts at expiry are realized through financial compensation between the
price at expiration and the price at which the contract was concluded, and can be implemented
as a physical futures contract through the spot market. The total volume of trade with power
derivatives on the EEX exchange in 2013 was 1,264 TWh, while the spot market recorded a
trade volume of 346 TWh [3]. For comparison, the Nord Pool spot market recorded a trade
volume of 493 TWh in 2013. Power derivatives and the number of market participants is what
makes EEX the current leading power exchange in Europe.
29


Figure 3-15. Greater trading area on EEX [2]

In following chapters, the structure of both spot and derivatives market (futures and option
contracts) is explained. As a reference market EEX was chosen, because it has the greatest
potential for expansion, due to well-structured derivatives market, a growing number of
market participants and a stable growth of trade volume.
3.4. Spot market
Financial spot markets and spot commodity markets are generally well-organized markets
in which goods and money are delivered immediately after the transaction on the exchange.
Due to high transaction costs, the spot market typically offers only standardized products for
trade in goods.
Electricity spot market is not organized as a market with delivery immediately after
transaction. Due to the impossibility of storing electricity, instant delivery is possible only in
exceptional circumstances. Therefore, spot electricity market can be divided into two distinct
markets: the day-ahead spot market and intraday spot market.
30

Trade at the day ahead spot market is organized on power exchanges under the principle of
equalization of supply and demand for each hour of the following day. The offer comes from
the surplus production that can not be sold in the long term. It is similar to the demand, as in
the case of unforeseen loads and demand, traders and large consumers can purchase additional
electricity on the spot market. In some cases, the manufacturer buys electricity because it can
not fulfil its contractual obligations or if the market price is lower than the costs of production
units.
Trading products on the day ahead spot market has been standardized and market rules are
the same for all market participants, buyers and sellers, which makes the market operator
neutral during execution of transactions. Except various delivery periods of electricity, on the
spot market base load (electricity supply throughout the next day) and peak load (delivery
during peak loads in a day, depending on the market) are traded. The competition between
producers, traders, speculators and large industrial consumers is achieved when the
submission of tenders for the purchase and sale are delivered to the exchange.

Figure 3-16. Offers for buy/sell of one participant at the day-ahead auction
Each offer contains the quantity and a minimum/maximum price at which a market
participant is willing to sell/buy electricity. Immediately after the expiration of the time for
sending bids, exchange operator from all of the offers received, forms a supply and demand
curve and publishes a determined price for each hour of the following day. Only offers for
sale that are lower than the determined price and offers to buy that are above the determined
price will be executed, and all of them will be matched at the determined price. This process
is called a uniformly valued auction. Figure 3-16. shows offers to buy/sell electricity maid by
MWh
EUR/MWh
100
80
60
40
20
10 20 30 40 50
Offers to sell
Offers to buy
31

one participant of the market for a specific delivery period. Each participant of the market
must send their offers.
Intraday market is a market for continuous trade and quick delivery of electricity. A trader
can access the market when, for whatever reason, there is an immediate lack of power/energy
that should be delivered. This situation demands a quick solution and intraday market serves
for that purpose. Prices in this market are significantly higher than on the day-ahead spot
market and mainly electricity blocks of one hour are traded.
EPEX SPOT covers the spot market in Germany, Austria, France and Switzerland with
headquarters in Paris and offices in Leipzig, Bern and Vienna. The market was created in
2008 by merging companies, and related spot markets, Powernext SA from France and EEX
AG from Germany. EPEX SPOT currently has 222 registered participants. The total trade
volume recorded in 2013 was 346 TWh, while in Germany/Austria 265.5 TWh was recorded.
Compared with consumption in Germany, which in 2013 amounted to 596 TWh, 40% of total
electricity consumption in Germany was bought on the spot market. EPEX SPOT market is
organized as a day-ahead spot market and intra-day spot market.
EUR/MWh
300
200
-100
0
100
6000 7000 8000 9000 10000
Offers to sell
Offers to buy
MWh
DMP
DMV

Figure 3-17. Summarized offers to buy/sell at a determined market price and volume
32

Day-Ahead spot market is organized through uniform auctions at which all market
participants send their offers to buy/sell. After the tenders are received and auction expires,
EPEX SPOT summarizes all offers, and after equalization of supply and demand publishes
the determined market price (DMP) and determined market volume (DMV) for a specific
delivery period. An example is shown in Figure 3-17.
Delivery periods for a particular hour, blocks of several continues hours, base load, peak
load and supplies for the weekend are all separately traded or determined from a shorter
delivery period. Auctions are held every day and end at noon for Germany/Austria and French
area, while in Switzerland ends an hour earlier, and the results are published soon after
(usually 15 minutes after).

Figure 3-18. Prices for each hour on the Germany/Austria spot market from 2000. to 2014.
Offers to buy/sell contain up to 256 combinations of price/quantity of MWh for delivery in
one hour of the following day, while prices for 1 MWh must be in the range from -500
/MWh to 3000 /MWh. Minimal trading increment for delivery quantity is 0.1 MW, and
minimal trading increment for the price is 0.1 /MWh. EPEX SPOT is the first power
exchange which introduced negative rates in 2008, starting with the day-ahead spot market in
Germany/Austria. Negative prices are not a theoretical concept. The buyer on the spot market
receives electricity, and if the price is negative, receives money as well. Figure 3-18. shows
33

prices from the day-ahead spot market in Germany/Austria for each hour of delivery from the
creation of EEX spot market in Germany, from 15 June 2000. to 27 June 2014.
Market prices move in line with demand and supply of electricity, which is determined by
several factors such as climatic conditions, seasonal factors and consumer behaviour. Prices
are falling in the case of low demand, and falling into negative territory when inflexible
consumer can not be quickly and cost-effectively turned off and back on. Negative price
signals producers to reduce production and to compare the costs of turning the power plant off
and back on later with costs of selling electricity at the negative price. Renewable energy
sources (wind and solar power) also contribute to the decline in market prices in the case of
low demand, because of their rights of first purchase and production dependence on hardly
predictable external factors (wind and solar).

Figure 3-19. German delivery zones with their transmission system operators (TSOs) [8]
Location of delivery and trade of electricity on the spot market is defined by zones of
transmission system operators. When sending offers to an auction zone of delivery must be
specified in the offer. In France there is only one zone of delivery under the control of the
French system operator "RTE". In Switzerland, there is also only one zone of delivery under
the control of the Swiss system operato "Swissgrid". In Germany, there are 4 different zones
with 4 separate transmission system operators: Amprion GmbH, Tennet TSO GmbH, 50Hertz
34

Transmission GmbH and TransnetBW GmbH. Austria has only one zone of delivery with
TSO Austrian Power Grid. These 5 delivery zones in Germany/Austria form a single zone for
the formation of the final price on the auction, or the same price for all zones.
Trade with blocks of electricity is based on a combination of several hours of delivery.
Offers must be sent to auction where the quantity of delivery does not have to be the same for
each hour of delivery within the block. Offer/transaction of the entire block will be executed
on the exchange for all specified hours of delivery in the original tender or it will not be
executed. Trade of particular hours of delivery has a higher priority than a trade of block, as
the price of blocks is based on the determined prices for delivery periods of one hour. Block
price offer is compared with the realized volume-weighted average market prices of hourly
delivery periods contained in the block. On that basis it is determined whether the block
transaction will be executed or not.
Table 3.1. Standard block offers and prices in Germany/Austria, 2014. [9]
23. June 24. June 25. June 26. June 27. June 28. June 29. June
Monday Tuesday Wednesday Thursday Friday Saturday Sunday
Middle Night
(01-04) 23.14 29.1 28.71 29.57 29.77 30.28 25.78
Early Morning
(05-08) 28.57 34.48 33.79 34.56 33.68 28.05 21.78
Late Morning
(09-12) 35.03 50.6 44.87 45 44.2 32.17 28.96
Early Afternoon
(13-16) 36.25 43.75 40.11 41.44 37.56 29.67 28.54
Rush Hour
(17-20) 44.01 41.11 40.94 46.1 38.83 33.52 29.64
Off-Peak 2
(21-24) 40.17 39.04 38.92 41.7 38.85 34.68 33.33
Night
(01-06) 22.77 28.88 28.42 29.18 29.4 29.22 24.72
Off-Peak 1
(01-08) 25.86 31.79 31.25 32.06 31.72 29.17 23.78
Business
(09-16) 35.64 47.18 42.49 43.22 40.88 30.92 28.75
Off-Peak
(01-08 & 21-24) 30.63 34.21 33.8 35.27 34.1 31 26.96
Morning
(07-10) 35.11 44.68 42.32 43.25 41.83 30.67 23.7
High Noon
(11-14) 35.34 49.45 42.93 43.06 41.69 31.37 30.67
Afternoon
(15-18) 38.46 40.36 39.31 42.17 35.8 29.75 27.29
Evening
(19-24) 42.74 40.18 40.1 44.07 39.64 35.16 32.86
Sun Peak
(11-16) 35.81 46.62 41.68 42.36 39.51 30.44 29.52
Blok prices

35

On the intraday spot market, introduced in 2006, electricity is traded continuously up to 45
minutes (Germany and France, while in Austria and Switzerland, 75 minutes) before delivery.
Continuous trading is available for Germany, Austria, France and Switzerland, with similar
rules and characteristics for all four markets. The most advanced is the German intraday spot
market which rules and characteristics are discussed below.
The minimum trade volume increment is 0.1 MW, with a minimum price increment of
0.01 /MWh and allowed price range from -9999 to 9999 . With standard hourly deliveries
of electricity and blocks for base load (from 1 to 24 hours) and peak (from 9 to 20 hours every
day) load, on the German intraday spot market even 15-minute delivery periods are traded.
Starting every day at 15 o'clock continuous trading for delivery the following day is
conducted in hourly, 15-minute or block deliveries up until 45 minutes before the delivery.
Besides the standard blocks of delivery, market participants can create their own delivery
blocks consisting of several consecutive hours by choice.
Continuous trading is very different from an auction mechanism. Trading is mostly done
electronically. When sending a offer to buy/sell for a specific delivery period, price and
quantity of delivery must be specified and if there are other offers to sell/buy at that price and
with sufficient quantity, the transaction will be immediately or partially matched without any
price determination by the exchange. Almost always there is an immediate best open offer to
sell ("ask") and buy ("bid") at which transactions can be matched. Trader may decide that he
does not want to buy at the current price and gives the order to buy at a lower price and waits
for his open order to be matched, and the same goes for the opposite. There are several types
of offers which can be sent to the exchange with different modes of execution. Offer types for
the German intraday market are:
Limit order Offer to buy/sell that can only be matched at the determined or better
price, depending on whether it is an offer to buy, then the better price is the lower one,
or offer to sell, then the better price is the higher one.
Market Sweep Order Offer to buy/sell seeking the best deal in a given zone of
delivery, but also in other areas and countries.
10th MW Orders Bids for buy/sell of an extremely small volume of delivery from
0.1 to 0.9 MW.
Methods of offer execution are:
36

Immediate or cancel (IOC) The offer will be immediately matched when sent,
otherwise it will be cancelled.
Fill or Kill (FOK) Similar to the IOC with a difference that offer must be fully
matched at the determined or better price. There should be enough volume for the
offer to be fully matched, otherwise it will be cancelled.
All or None (AON) The offer will be received by the exchange and will be fully
matched at the given price or better, otherwise it remains as an pending offer on the
exchange until it is fully matched.
Iceberg One big offer which is divided into several smaller offers, usually with the
help of automated programs for the purpose of concealing the actual amount of the
offer, in this case the amount of MWh.

Figure 3-20. Prices on intraday spot market in Germany on June 24, 2014th
Prices on intraday spot market can fluctuate greatly depending on the needs for balancing
the delivery and other unpredictable factors. Figure 3-20. shows the highest, lowest and last
price of matched transactions for the supply of power by the hour in Germany on June 24. For
example, the delivery of electricity in a period 08-09 hours, the lowest matched price is below
30 /MWh, and the highest, is around 45 /MWh.
37

Difference in matched prices of 15 /MWh for the same delivery hour, which is 50% with
respect to the lowest matched price, indicates high volatility on intraday spot market. Market
participants can take advantage of high volatility for the sale of contracted deliveries from the
day-ahead spot market at higher prices, if the delivery can be covered in a different way or if
it is a surplus. In the case of higher prices, producers can sell excess electricity which they
currently have available or if they failed to sell on the day-ahead spot market or bilaterally.
Market participants, traders or consumers who have unpredictable demand and/or did not
meet their needs to deliver from the day-ahead spot market or bilaterally, can access the
market and secure a sufficient amount of energy to deliver. Excessive demand is often on the
intraday spot market, and with it a higher price than on the day-ahead spot market for the
same delivery period. With the introduction of even shorter delivery period (15 minutes was
introduced in Germany and Switzerland) it is now more possible to better balance the
unpredictable demand and production from renewable energy sources, and therefore the
prices on the intraday spot market. In order to reduce price volatility in both spot markets and
increase the delivery quality of electricity, market coupling has been introduced.

Figure 3-21. Balancing price between areas with different supply/demand [10]
Connecting a day ahead spot market mostly works on an auction basis, taking into account
the transmission capacity between countries. In the lower price area the demand curve shifts
to the right, and in the area of higher prices supply curve also shifts to the right by the amount
38

of transmission capacity between areas. The result is a balance between price areas. Figure 3-
21. shows an example of balancing prices between two day-ahead spot markets.
Market coupling of day-ahead spot markets on EPEX SPOT exchange is held every day
starting at 9:30 - 11:15 am. Delivery contracts of one hour are traded. Auction forms are:
EPEX SPOT France to Germany delivery from France to Germany
EPEX SPOT Germany to France delivery from Germany to France
EPEX SPOT France to Belgium delivery from France to Belgium
EPEX SPOT Germany to Netherlands delivery from Germany to Netherlands
EPEX SPOT France to Spain delivery from France to Spain
EPEX SPOT France to UK delivery from France to UK
EPEX SPOT Germany to Denmark delivery from Germany to Denmark
Denmark to EPEX SPOT Germany delivery from Denmark to Germany
Market coupling of intraday spot markets between EPEX SPOT markets/countries is based
on active and continuous linking offers to buy and sell, taking into account the transmission
capacity between countries. Without market coupling markets in Germany, the visible supply
and trade exists only between consumers, producers and retailers from the German delivery
area (local area). By connecting the German and French markets, continuous trading for the
German area has local offers and best offers to buy/sell from France and conversely, but only
if there is available transmission capacity between countries. The aim is to decrease price
differences between countries so there are no additional costs for the purchase/sale of
electricity, or for the transmission of electricity between countries. In trading on the exchange,
if both parties of the transaction are from the same delivery area, further delivery process is
relatively simple. In the case of trading between countries, it is necessary, at all times, to
amend the automatic transmission capacity between countries and an active communication
between TSO of the countries. In both cases, the registration of trade and delivery is regulated
by ECC AG (European Commodity Clearing) company.
The total trade volume of 16.3 TWh on intraday spot market in 2013 is considerably lower
then the trade volume on the day-ahead spot market (330 TWh). Hereinafter, day-ahead spot
market will be considered as spot market.
At the end of each auction on the spot market, certain prices for each hour are used for
indexes that represent the price for a period of delivery in a given area. For the
German/Austrian delivery area Phelix index is computed, as Phelix Base and Phelix Peak
39

index. Phelix Day Base index represents the base load for one day and it is calculated as the
arithmetic average of all hourly prices (0-24) for delivery determined on the auction. Phelix
Day Peak index represents the peak load for one day and it is calculated as the arithmetic
average of the hourly prices for delivery from 8 to 20 hours determined on the auction. With
daily indices, there are also monthly indices, Phelix Base Month and Phelix Peak Month,
which are calculated as the arithmetic average of all daily Phelix indexes in the month. Figure
3-22. shows the Phelix Day Base index as the average hourly prices of each day from 2000 to
2014. Most other indices are calculated according to the similar or the same principle.

Figure 3-22. Phelix Day Base index from 2000. to 2014.
Market coupling has reduces volatility, as can be seen in Figures 3-18. and 3-22. Following
the introduction of negative prices in 2008, the number of price jumps on levels over 100
/MWh has decreased. With negative jumps becoming more rarer, the price has stabilized in
the last few years on levels between 30 and 50 /MWh. Figure 3-23. shows the frequency
histogram of Phelix Day Base index during the period from 2000 to 2014 with a sample of
5125 prices. The histogram would be approximately normally distributed according to the
Gaussian curve if there were no prices prior to 2009. Frequency histogram of the prices for
the period from 2009 to 2014 with a sample of 2000 prices is shown in Figure 3-24.
40


Figure 3-23. Frequency histogram of Phelix Day Base index from 2000. to 2014.

Figure 3-24. Frequency histogram of Phelix Day Base index from 2009. to 2014.
41

Phelix peak index should always be greater than Phelix base index because it is generally
higher average demand for electricity from 8 to 20 hours than the average demand throughout
the day. Appearance of the Phelix Day Peak frequency histogram is relatively the same as for
the Phelix base index.

Figure 3-25. Phelix Day Peak index from 2000. to 2014.
With the increasing construction of photovoltaic power plants in Germany and the current
installed capacity of 36 GW [11], during sunny days peak price is more often lower than the
base price of the index. Production capacity of renewable and conventional sources of
electricity is growing from year to year and currently equals 171 GW in Germany. An average
load of 50 to 70 GW, share of production from renewables equals 25.4% and 74.6% from
conventional sources. Increasing production capacity with insufficient increase in spending
and the right of pre-emption of photovoltaic power has changed the way electricity markets
function. Figure 3-26. shows the production from photovoltaic power plants in Germany in
one day, June 26, 2014. Figures 3-27. and 3-28. show the percentage price difference between
peak and base Phelix Day indexes. During the summer months, from May to October, there is
less difference between peak and base index, and on sunny days it is often that peak index is
lower than the base index. During winter months, the difference between indexes generally
ranges from 5 to 15 /MWh last 5 years, with occasional jumps above 20 /MWh.
42


Figure 3-26. Production from photovoltaic power plants in Germany, 26 June 2014 [11]

Figure 3-27. Percentage price difference between peak and base Phelix day indexes
43


Figure 3-28. Percentage price difference between peak and base day indexes last 6 years
Peak and base index and block prices of delivery only take into account average hourly
prices within a day, while the cost of hourly electricity supply can vary greatly depending on
the market situation. Figure 3-29. shows the average cost of hourly electricity supply on the
spot market for delivery in Germany/Austria in each year from 2002 to 2013. From 2002 to
2009 price periodicity is revealed. Lowest price is at 4 am, followed by increase in price to
day high at noon, a slight decrease in the afternoon with the leap around 7-8 pm and further
drop of prices until midnight. From 2010 till today, price periodicity is the same as for the
previous year, but with a smaller price increase during the day due to larger production from
photovoltaic power plants than in previous years. The highest price is no longer during the
day, but at night at around 8 pm. For the period from 2011 to 2013, price at 8 pm was around
5 /MWh higher than the price at noon, while the 2010 price at noon and at 8 pm was
approximately the same. Figure 3-30. shows the average cost of hourly deliveries in the
period from 2002 to 2013, and separately for the period from 2002 to 2009 and from 2010 to
2013.

44



Figure 3-29. Average prices of hourly deliveries per year
45


Figure 3-30. Average prices of hourly deliveries
Prices also vary depending on whether it is a business or non-business day. Figure 3-31.
shows the average electricity price in Germany/Austria by days of the week for each year
from 2002 to 2013, and Figure 3-32. shows the average price per day of the week for period
from 2000 to 2014. Figure 3-33. represents the average hourly price by delivery days of the
week for 2013.
46



Figure 3-31. Average price per day of the week
47


Figure 3-32. Average price per day of the week from 2000 to 2014

Figure 3-33. Average prices of hourly deliveries by weekdays in 2013
48

3.5. Derivatives market
Due to high volatility in the spot market, market participants are exposed to risks when
trading on the spot market. The most important are the price risk, counterparty risk and
volume risk (ex. lack of liquidity in the spot market). With long-term contracts, which until
recently were not present on most power exchanges, derivatives market provides market
participants ability to protect and manage their risks. Long-term contracts bind contract
parties to deliver electricity (the underlying), during a given period in the future (delivery
period), and are known as derivatives.
Derivative is a special type of contract that has a current value based on expected future
price movements of the underlying asset. Derivatives are traded for:
Hedging, risk management
Arbitrage
Speculation
Market participants, producers, traders and large consumers, are using derivatives to hedge
against risk. Futures contracts can be bought to hold a long position, or sold before bought to
hold a short position. For example, the short futures contract can be used as a protection
against falling electricity prices by fixing the price for delivery in the future (the futures
price). Arbitrageur exploits the difference between prices in different markets on the same
tradable asset class. For example, the simultaneous purchase of a contract for supply of
electricity out of the market (bilaterally) at a reduced price and selling futures contracts on the
market at a higher price. Speculators trade derivatives in order to achieve profit by taking on
the risk of future price movements, thus providing liquidity to other market participants.
Power exchanges use many types of derivatives, but the most common are:
Futures contracts
Forward contracts
Options
In addition to these there are many other derivatives, standardized and non-standardized.
For the purpose of describing the electricity exchange EEX only standardized derivatives of
EEX exchange are taken into account, while non-standardized derivatives, mostly bilateral,
are not taken into account.
49

3.5.1. Futures contracts
A typical futures contract is a standardized, portable and binding contract to buy or sell a
specific amount of the underlying asset at a certain time in the future (the maturity of the
futures contract) at a specified contract price (futures price). Future contracts are used mainly
to reduce the risk future market prices by fixing the price to be paid/received for the delivery
of the underlying asset in the future. The risk for a buyer or a seller of a futures contract is the
same, because the amount of loss and gain of contract participants is the same (but opposite)
at any given time until expiry of the contract.
Expiries of futures contracts and the amount of supply of the underlying are standardized.
The only debatable aspect of the contract is the current price to be paid for the underlying at
some point in the future, or futures price. Contract Standardization is carried out in order to
facilitate trade in futures markets.
Future price at time t for delivery of the underlying asset, with the price on the spot market
S(t) and the expiration of the contract at time t, is expressed as f (t,T). Payment (P) of a
futures contract at expiration T is expressed as:

() ( )
(3.1)
To avoid arbitrage, from relation above we see that the futures price agreed at the time T,
for the delivery of the underlying asset at the time T (instant delivery), must be equal to S(T).
Any other price would allow arbitration, by buying the cheaper and selling the other.
Having to pay the contracted futures price in given time in the future, there are no costs of
concluding the futures contract. However, due to market conditions, the value of futures
contracts change over time. For example suppose that the market participant has a long
position for delivery of the underlying asset in the future at a market price of 100, and the
current market value of the contract is 110 . If market participant sells the contract at the
current price, he will realize an immediate profit of 10 and will no longer have any liability
in connection with the delivery of the underlying asset in the future.
The value of each futures contract is recorded at the end of each trading day. This means
that financial positions are valued according to current market prices as shown in the previous
example. The difference between the price of the previous day and current prices are
continuously determined. Profit or loss of a position is added to or subtracted from the
account of a market participant. Since there is a risk involved when trading futures, exchanges
50

are using margin accounts that guarantee that contracts will be respected. Margin is
determined by how much money you should have in your account when you trade futures
contracts and is usually only couple or more percent of the total futures price, and if the
position is in negative territory even more.
Trading futures contracts on exchanges is relatively straightforward and ultimate delivery
of the underlying asset rarely happens when the contract expires. Sellers and buyers usually
break commitments by exiting their positions prior to the expiration of the contract.
The above-described typical futures contracts differ greatly from futures contracts that are
traded on power exchanges. In a typical futures contract underlying asset is being bought/sold
and delivered in a given time in the future, or when the contract expires. Power futures
contract expiration and delivery do not match. Instead of a specific date of delivery, electricity
is delivered through a contractually specified period of time. Contracts with different delivery
periods are traded, but the most common periods are one month, quarter and year. Power
futures contract is a binding agreement for delivery of the contracted quantity of electricity
during the delivery period. Futures contract for delivery in 2015, is a contract which obliges
the delivery of 1 MW of power during each hour of the delivery period (in this case during the
entire year, and the total energy delivered will be 1 MW 8760h = 8760 MWh).
The price of a power futures contract at time is expressed as (

), where

represents the beginning and

the end of the delivery period. With spot price represented as

(), where

, payment () for a long position in power futures contract is

expressed as:

()

) (

)
(3.2)
Payment () for a short position in power futures contract is expressed as:

(

) (

) ()

(3.3)
From (3.2) and (3.3) it is clear that the underlying asset of a power futures contract is not
the spot price in a given time in the future, but the arithmetic average of hourly spot prices
during the delivery period. The above fact makes it difficult to model prices of power futures
contracts.
51

On the EEX derivatives market transactions are executed between anonymous offers
received by the Exchange. Buyers and sellers submit their bids to buy/sell with given prices
and quantities of a particular futures contract. The principle of trade is similar to the intraday
spot market, because it is a continuous trading market. Trade takes place mostly on weekdays,
from 8 am to 6 pm.
On EEX Derivatives Market it is possible to trade with:
Phelix base, peak and off-peak futures (financial, possible physical delivery)
French base and peak futures (financial, possible physical delivery)
Italian base and peak futures (financial)
Dutch base and peak futures (physical)
Belgium base and peak futures (physical)
Physical futures contracts are realized through physical delivery of electricity at expiry.
Financial futures contracts are realized through financial compensation between the price at
expiration and the price at which the contract was concluded, and they can be implemented as
a physical futures contract through the spot market. On the EEX derivatives market it is
possible to register base financial futures contracts with delivery in Romania, Switzerland,
Spain and the "Nordic" delivery area (Scandinavian and Baltic countries). The highest trade
volume on the EEX derivatives market is on financial futures market, specifically the market
for Phelix futures contracts. In addition to futures contracts, options which have futures
contracts as the underlying are traded as well. For now there are only options for Phelix Base
futures contract. Because of this, from now on in the thesis, only Phelix futures contracts are
discussed.
Underlying asset of the Phelix Base futures contract is the Phelix base index for all days of
delivery during the delivery period. Phelix Base Index represents the base load and it is
calculated as the arithmetic average of all hourly prices (0-24) for delivery on the spot
auction. Underlying asset of the Phelix Peak futures contract is the Phelix peak index for all
days of delivery during the delivery period. Phelix peak index represents the peak load and it
is calculated as the arithmetic average of peak hourly price for delivery (from 08:00 to 20:00)
on the spot auction. Underlying asset of the Phelix off-peak futures contract is the Phelix off-
peak index for all days of delivery during the delivery period. Phelix off-peak index
represents the off-peak load and it is calculated as the arithmetic average of off-peak hourly
prices for delivery (from 12:00 a.m. to 8:00 and from 20:00 to 24:00) on the spot auction.
52

Delivery periods are: day, weekend, week, month, quarter and year for base and peak
Phelix index, while for off-peak index there are only delivery periods for one month, quarter
and year. Trade of delivery periods for certain futures contracts is possible for:
Day futures contracts next 34 days
Weekend futures contracts next 5 weekend
Week futures contracts next 4 weeks
Month futures contracts next 9 months
Quarter futures contracts next 11 quarters
Year futures contracts next 6 years
Characteristic of quarterly and annual futures contract is that they are cascading or
separating on futures contracts with shorter delivery periods on the third day of trading prior
to the start of delivery. Quarterly futures contract is broken down into three monthly futures
contracts, and the annual futures contract is broken down into three monthly contracts
(January-March) and three quarterly contracts (from April to the end of the year). Quarter and
annual futures contracts are traded until separation, and futures contracts with shorter delivery
period are traded up to the start of delivery or up to few days before the end of the delivery
period, depending on the contract. Monthly, weekly, weekend and daily futures contracts are
not cascading. Through them delivery of electricity is conducted (with physical futures
contracts) or cash compensation is made (in financial futures contracts).
When trading futures, possibility of arbitration emerges between futures contracts with
different periods of delivery for the same delivery period. At the end of each day trading day,
if there was not enough liquidity, exchange determines the price for each futures contract
while taking into consideration that prices must meet the requirement of inability of
arbitration. For example, the following relationships must be valid when determining annual
and quarterly price contracts:
For the annual futures contract:

(3.4)
Where

is the annual futures contract price,

is the quarterly futures price for the first

quarter and h is the delivery quantity of the contract.

53

For the quarterly futures contract:

(3.5)
Where

is the quarterly futures price for the second quarter,

is the monthly futures

price for the forth month, a h is the delivery quantity of the contract. Figure 3-34. clearly
presents the overlap between the delivery periods of futures contracts, conditions that have to
be met in order to satisfy the condition of no-arbitrage and separation of annual and quarterly
futures contract on futures contracts with shorter delivery periods.
2013 (Y13)
Q1 Q2 Q3 Q4
M1 M2 M3
2013 (Y13)
Q2 Q3 Q4
M1 M2 M3
M4 M5 M6 M10 M11 M12 M7 M8 M9
M4 M5 M6 M7 M8 M9 M10 M11 M12

Figure 3-34. Cascading futures contracts and no-arbitrage condition [2]
The largest trade volume is on base annual futures, because of hedge trades by producers,
consumers and suppliers of power. Figures 3-35. and 3-36. show price movements of base
futures contract from 2008 to 2014 for delivery periods from 2010 to 2014. Figure 3-37.
presents price movements of base futures contract from 2012 to 27th of June 2014, for the
delivery periods from 2015 to 2018.
54


Figure 3-35. Annual base futures contracts from 2008 to 2010 with different delivery periods

Figure 3-36. Annual base futures contracts from 2008 to 2014 with different delivery periods
55


Figure 3-37. Annual futures contracts from 2012 to June 2014 with different delivery periods
Price volatility before 2010 is substantially higher than in the coming years. For example,
in 2009 a difference of over 15 EUR/MWh was recorded between annual futures contracts for
delivery in 2010 and 2014 (difference in the delivery of 4 years), and a difference of 10
EUR/MWh was recorded between annual futures contract for delivery in 2010 and 2012
(Figure 3-35.). Equivalently at the beginning of 2014, the current year before the start of
delivery of a futures contract for 2015, the biggest difference of just a few EUR/MWh was
recorded between futures contracts for delivery in period from 2015 to 2018. Until April
2014, future contracts with later delivery period had a higher price than future contracts with
earlier delivery periods, while the current futures contract with delivery in 2015 has the
highest price (Figure 3-37.).
Higher prices of futures contracts with later delivery periods can be interpreted as
uncertainty or risk of high electricity prices in the future, which was obviously much higher
few years ago than today. Stabilization of prices may contribute to a growing number of
market participants, real electricity traders or speculators, and to increased production
capacity of renewable energy sources that contributed to higher competition among
conventional electricity producers.
56

Price movements of annual futures contract since 2008 to 27 June 2014 with delivery
periods from 2010 to 2018 are shown in Table 3.2. All amounts are in euros and refer to one
futures contract with 1 MW of constant delivery during the delivery period. Recorded
averages are: lowest price 38.74, highest price 80.68, arithmetic mean 54.53 with a
standard deviation of 10.36 and volatility of 19.7%. Figure 3-38. shows daily price
movements on the spot market (Phelix Base day index) and the current annual base futures
contract price with delivery in the next year from 2009 to 2014.
Table 3.2. Price movements and averages of annual base futures contracts


Figure 3-38. Daily prices on the spot market and current annual futures contract price
Delivery period Low High Arithmetic mean Standard deviation Volatility
2010 42.65 89.00 59.20 11.87 20.1%
2011 45.19 89.67 57.91 10.25 17.7%
2012 48.43 90.30 59.32 8.64 14.6%
2013 45.07 96.30 60.03 10.43 17.4%
2014 36.25 96.80 57.54 12.60 21.9%
2015 33.77 72.00 52.78 10.69 20.3%
2016 33.15 68.40 50.83 10.45 20.6%
2017 32.11 65.25 48.59 10.29 21.2%
2018 32.00 58.42 44.61 8.04 18.0%
Average 38.74 80.68 54.53 10.36 19.07%
57

3.5.2. Forward contracts
Like a futures contract, forward contract is a binding agreement to buy or sell a specific
amount of the underlying asset at a certain time in the future at a specified contract price.
Unlike futures contracts, which are usually traded on an exchange, forward contracts are
mostly traded bilaterally and contractors usually adapt the contract to their needs.
Future contracts, as previously shown, are standardized contracts that are traded and priced
on exchanges between large number of trading participants. By using margin accounts and
exchange as an intermediary for all financial transactions, delivery risk is minimal that futures
contracts will not be respected. For this reason an increasing number of bilaterally agreed
futures contract are registered on the exchange. Forward contracts are private contractual
agreements and contract participants are exposed to the risk that counterparties will not
comply with the contract.
Assuming a deterministic interest rate, forward and future contract prices will be same for
contracts with the same beginning and delivery period. Therefore only futures contracts traded
on the EEX are taken into account.
3.5.3. Option contracts
There are two basic types of options: call and put. A call option gives the holder of the
option the right, but not the obligation, to buy the underlying asset at a given time in the
future (at option expiry - T) for a price agreed upon purchase of the option (strike price - K,
the exercise price). A put option gives the holder of the option the right, but not the
obligation, to sell the underlying asset at a given time in the future for a price agreed upon
purchase. These options, where owner only has the right to exercise the option on expiration
date, are known as the European option. There are many other types of options such as the
American options (possible exercise of the option at any time until expiration) and Asian
options (option premium depends on previous price movements of the underlying asset).
Options are only traded on exchanges. Basically there are two types of options on power
exchanges. European options with futures as the underlying asset and Asian options with spot
price as the underlying asset. Highest trade volume is registered on European options with
annual base future contracts as the underlying asset and they are considered in this Thesis.
As with classic European option, the owner of an European call option written on power
futures contract, has the right, but not the obligation, to buy a futures contract at strike price
58

when the option expires. If the futures contract price is defined as (

), payment of a
European call option () upon expiration , written on a futures contract with delivery period
from

to

is defined as:

((

) )
(3.6)
Where

is hours of delivery of a futures contract on which the option is written (base

futures contracts deliver 1 MW during each hour of the delivery period).
Owner European put options written on a power futures contract has the right but not the
obligation, to sell a futures contract at strike price when the option expires. Payment of a
European put option () upon expiration , written on a futures contract with delivery period
from

to

is defined as:

( (

) )
(3.7)
On the EEX exchange, it is possible to trade with European call and put options with
Phelix base futures as the underlying asset. There are options written on futures contracts with
delivery period of one month, quarter and year. EEX exchange offers additional options with
different expiration times written on annual futures contracts. Option expirations are before
the start of delivery period of the futures contract (an additional 4 different expiry times). The
option will be of value during expiration if the strike price is lower/higher (call/put option)
then current market price of the futures contract , according to (3.6) or (3.7), and the owner of
the option will exercise it, because it is in the money. If the strike price is lower/higher than
the current price of a futures contract on which the options are written (if the option is out of
the money) owner of the option will allow the option to expiry without exercising it. If the
option has a positive value, the owner of the option will execute the option and now hold the
futures contract at strike price that is more favourable than the current price on the exchange.
When buying options, the buyer pays the premium. The option buyer has a theoretical
possibility to achieve infinite profits at the risk of losing the premium. The seller receives the
option premium when selling options, but there is a theoretical risk of an infinite loss. Actual
payment to the option holder is obtained when we take into account premiums paid during
purchase (3.6) and (3.7). If you define the call option premium as

and call option premium

as

, the actual payments to the option holder at expiry are defined according to (3.8) and
(3.9).
59

Actual payment to the owner of the call option:

(((

) )

)
(3.8)
Actual payment to the owner of the put option:

( ( (

) )

)
(3.9)
The option premium depends on several parameters such as exercise price, time to
expiration, the volatility of the underlying asset, interest rate of the currency in which the
underlying asset is traded, and the anticipation of future price movements of the underlying
asset. Figure 3-39. shows dependence of the premium price to the strike price, on one trading
day June 25 2014, for call options written on annual futures contracts with expiration in 2015
and 2016 (both futures and options). Figure 3-40. shows the equivalent dependence for the put
option. Figures 3-41. and 3-42. show movements in premiums for call and put options in
2014, until the end of June, with two different exercise prices (35 and 40 / MWh) and two
delivery period (2015 and 2016). For ease of comparison with the premiums, Figure 3-43.
shows price movements of annual futures contracts for delivery in 2015 and 2016.

Figure 3-39. Dependence of call option premium on strike price
60


Figure 3-40. Dependence of put option premium on strike price

Figure 3-41. Movement of call option premiums from the beginning of 2014 until July
61


Figure 3-42. Movement of put option premiums from the beginning of 2014 until July

Figure 3-43. Price movement of annual futures contracts
62

4. MARKET SIMULATION MODELS
Previous two chapters present a general overview of the liberalized electricity market, as
well as insight into spot and derivatives market on EEX exchange. In line with the
liberalization process, power exchanges have become a place where manufacturers,
distributors, speculators, retailers, traders and large consumers trade different products of
electricity. Due to increasing trade volume it has become necessary that market participants
develop simulation models for price movements for contracts which they trade in order to
apply better risk management strategies and to evaluate there positions on the exchange. This
chapter presents a mathematical approach required for understanding, application and
development of simulation models for electricity.
Modelling electricity price movements can be achieved through three different approaches:
Fundamental approach
Stochastic approach
Hybrid approach
Fundamental approach is realized through use of fundamental variables for implementation
of simulation models that match historical data as closely as possible. It requires high
understanding and insight into the variables that influence changes in market prices. The
variables that affect the change in electricity prices are: power plant production costs,
expected consumption for the delivery period, fuel prices (gas, coal, oil), weather conditions,
transmission and installed network capacity, etc. Advantages of fundamental approach are the
ability to monitor variables that affect fluctuations in market prices and relatively simple
economic explanations for price changes. However, a large amount of data required for model
implementation and fitting with historical data, with constantly changing variables (one of
which is of great importance - temperature), makes this method very difficult to implement.
Therefore, the models for predicting future price movements based on a fundamental
approach are not used for periods longer than one week ahead.
Stochastic approach is realized through modelling of stochastic processes that represent
electricity prices. Historical data is used to estimate stochastic processes parameters with aim
of better matching of simulation model with historical data. Prices of electricity derivatives,
such as European options, can be obtained from stochastically modelled price movements of
the underlying asset on which the derivative is written. After analysing electricity markets it
63

can be concluded, with great confidence, that price movements in spot and futures markets are
random processes that can be modelled by stochastic processes. Problems of the stochastic
approach are lack of historical for accurate estimation of process parameters and on going
structural and regulatory changes in the ESI. Yet with all said, stochastic modelling of
electricity prices is a very active research and scientific topic.
The hybrid approach is implemented through the combination of fundamental and
stochastic approach. Many authors of the hybrid approach and results had shown that hybrid
model of electricity prices describes price movements well, even in extreme conditions of
sudden changes in fundamental variables (such as weather conditions, extreme load changes,
lack of production, and combination of the above).
Fundamental and hybrid approach require large amounts of data and assume an economic
connection (correlation) between tradable products on exchanges, which makes simulation
models very sensitive to parameter changes. This indicates a high risk of simulation models
when fundamental or hybrid approach is applied. In this paper focus is on the stochastic
modelling approach of electricity prices using historical data from EEX exchange.
4.1. Stochastic spot price modelling
Stochastic process is a mathematical formulation of a random motion formed by successive
random numbers. In this paper only processes that have Markov property were used. A
stochastic process has the Markov property if the conditional probability distribution of future
states of the process (conditional on both past and present values) depends only upon the
present state, not on the sequence of events that preceded it. A process with this property is
called a Markov process.
The model we describe in this paper will capture the following characteristics observed in
all known electricity markets:
Seasonal patterns and periodicities All markets show seasonal patterns of
electricity demand over the course of the day, week and year. Seasonal price
movement in the spot market is related to temperature, weather conditions, and
other fundamental variables, and it is therefore considered a deterministic
characteristics.
64

Price spikes Relatively frequent occurrence of extreme jumps in price on very
high or negative values. The jumps occur for fundamental reasons, but they are
often impossible to predict, and are therefore considered a stochastic characteristic.
Mean reversion Prices have the tendency to quickly return from high or negative
levels to a mean level. Since jumps are defined as stochastic processes, mean
reversion can also be classified as a stochastic process, or a stochastic
characteristic.
Price dependent volatilities It turns out that in all markets there is a strong
correlation between price levels and levels of volatility.
Long-term non stationarity Due to increasing uncertainty about factors such as
supply and demand or fuel costs in the long-term future, a non stationarity model
seems more appropriate. Non stationarity is also needed for a model to be
consistent with the observed dynamics of futures prices.
Modelling electricity prices can be done using various stochastic processes, some of which
do meet the characteristics above and some do not. Most famous, and one of the first
stochastic process, is the Brownian motion which describes the movement of random numbers
with given mean value and volatility which can have negative and positive values. Geometric
Brownian motion (GBM) is considered a more advanced version, but may only take positive
values and is therefore widely used in modelling assets and securities on financial markets.
Since the introduction of negative values on the exchange, GBM can not be used as a separate
process for modelling electricity prices. Even before the introduction of negative prices, these
processes had not represented spot prices well, due to lack of mean reversion.
Mean reverting stochastic processes are characterized by a typical mean price to which the
process strives, strength or speed of return to the mean price and volatility of the process. The
mean price does not necessarily have to be fixed, but may also be a separate function or a
process, which represents spot price movements well. The problem with modelling prices
with a mean reverting process continues to be sudden jumps in price to extreme levels.
Adding stochastic jumps to mean reverting processes achieves satisfactory results.
In addition, the use of models with stochastic volatility instead of fixed volatility can be
used in all of these processes. A major problem in stochastic modelling is the determination of
process parameters in order to fit simulation model with historical data. Many methods are
used to determine the parameters depending on the process being modelled, most of which are
extremely complex and difficult to implement, and are out of the scope of this paper. In this
65

paper, the least squares method and maximum likelihood estimation is used to determine
process parameters.
Modelling spot prices can be conducted by first determining the seasonal/periodic
component of historical data, so that stochastic process models the rest. By using mean
reverting process and modelling mean level as a separate process or floating variable, spot
prices can be simulated without prior separation of the seasonal component.
The focus of this paper is to describe the most popular stochastic processes used to model
the movement of prices on power exchanges and less on determining the process parameters
in order to better fit the model with historical data. Exact matching of models with historical
data does not guarantee that process parameters, or the model itself, will be valid in the future.
Simulation models are used primarily for risk management and business development, and not
to predict future price movements.
The following section explains the most important processes for modelling electricity
prices. For comparison with the simulation models historical prices for German /Austrian
delivery area were selected (Phelix daily base index), in period from 2008 to June 2014
(Figure 4-1.). Prior to this period there were no negative prices in the market, and because of
the fundamental mismatch with the current functioning of the exchange, prices prior to 2008
will not be considered. Price trends on the spot market before 2008 are shown on figures in
third chapter.

Figure 4-1. Phelix Base daily index in period from 2008 to June 2014
66

4.1.1. Basic statistical analysis
The basis of any data analysis is descriptive statistics which gives insight into data
distributions. The most important values are arithmetic mean, standard deviation, coefficient
of skewness and kurtosis coefficient.
Mean (average) for N prices S on spot market is defined as:

()

(4.1)
Standard deviation for N prices S on spot market is defined as:

(() )

(4.2)
Asymmetry coefficient (CA) indicates asymmetry around the mean of observed data [12].
Classical normal distribution is symmetric around the mean and has a value of CA equal to
zero. If distribution is tilted to the right, or if it has a thicker right end, CA will be positive,
and if it is a left end of distribution CA will be negative. CA value of data on the spot market
is defined as:

()

(4.3)
Kurtosis coefficient (KC) completes the picture of the layout of distribution, because it
numerically describes the curvature in the vicinity of distributions peak [12]. Curvature of the
normal distribution is equal to 3. In the event that the KC is greater than 3, distribution is
more acute, it is narrower and has a higher peak than the normal distribution, and if it is less
than 3, distribution is flatter, lower and wider than the normal distribution. KC of prices on
the spot market is defined as:
67

()

(4.4)
By linking these coefficients, "Jarque-Bera" test (JB) is used to measure the normality of
the observed data [12]. Critical value at which the observed data could be considered normal
is 5.99 while JB value of spot price distribution is 1260.9 (Table 4.1) which concludes that
observed prices on the spot market are not normally distributed. JB test is defined as:

( )

)
(4.5)
Figure 4-2. shows the distribution of observed prices (blue) and normal distribution (red)
with an average value and standard deviation of the observed data (Table 4.1.). Ordinate
represents occurrence frequency of a certain price expressed as a percentage, while abscissa
represents prices on the spot market in EUR/MWh. Distribution of observed data has a thicker
right end which is indicated by a positive CA and narrower and higher peak than the normal
distribution as indicated by KC.

Figure 4-2. Distribution of Phelix base index prices during the period from 2008 to June 2014


68

Table 4.1. Parameter values for spot market prices for a given period
Mean -
Standard
deviation -
Asymmetry
coefficient - CA
Kurtosis
coefficient - KC
Jarque-Bera test
45.7 /MWh 15.6 /MWh 0.54 6.4 1260.9

If we formulate daily returns/moves (DM) of spot prices as:


() ( )
()

(4.6)
Table 4.2. Parameter values for spot market daily returns
Mean -
Standard
deviation -
Asymmetry
coefficient - CA
Kurtosis
coefficient - KC
Jarque-Bera test
-1.94 % 43.97 % 7.8 219.03 4.6328e+06

Figure 4-3. shows the distribution of observed daily returns on the spot market (blue) and
normal distribution (red) with an average value and standard deviation of the observed data
(Table 4.2.). For modelling price movements distribution of returns is used more often than
price distribution. Extreme spikes substantially increase standard deviation of returns and it is
obvious that observed returns do not fit the normal distribution.

Figure 4-3. Distribution of spot price daily returns

69

Continuous monitoring of the mean price for a particular period provides insight into
movement characteristics of average levels used in mean reverting stochastic processes where
mean levels are not fixed. Figure 4-3. shows moving averages for periods of 30, 60 and 90
days. Shortest moving averages of 30 days follows sudden price changes, while moving
averages of 90 days rarely responds to sudden changes in price. If we compare Figures 4-1.
and 4-4., we observe that moving averages eliminate the "noise" and clearly show the level at
which the price is at a given time. Moving averages of 90 days is the best average price to
represent price trends over a period of several days and to point at the huge range of historical
prices, and thus representing unpredictability of future price movements.
Continuous monitoring of standard deviation for a certain period, provides insight into
movements of volatility of stochastic process that is used in all processes. Figure 4-5. shows
trends in standard deviation for a period of 30, 60 and 90 days.

Figure 4-4. Price moving averages (MA) of Phelix Base daily index
70


Figure 4-5. Standard deviation moving averages (MA) of Phelix Base daily index
4.1.2. Brownian motion
Process of Brownian motion (with drift) S(t) is obtained as a solution of the stochastic
differential equation (SDE) with a constant drift and constant intensity of the random
component (volatility) . SDE of Brownian motion is defined as [13]:

() ()
(4.7)
Where () represents the Wiener process of normally distributed random variable with
mean zero, variance dt and standard deviation , defined as:

()
(4.8)
Variable represents a random variable which is, for simulation purposes (in this paper),
defined as a sum of twelve random numbers with values ranging from zero to one reduced by
six (standard normal distribution). It is defined as:

()

(4.9)

71

By direct integration of (4.7) solution of the SDE, with intial value S(0):

() () ()
(4.10)
Hence S(t) is normally distributed, with mean () and variance

. Its density function

is defined as:

( )

(())

(4.11)

A Geometric Brownian Motion S(t) is the solution of an SDE with linear drift and
diusion coecients. The GBM is specified as follows:

() () () ()
(4.12)
In order to solve for S(t) we will apply Itos lemma to ln(S(t)) as follows:

() () [ ()]
(4.13)
(())
(())

()

()

(())

(())

()

(()) (

) ()
(())

()

()
()
(

) ()

() ()
(

)()

(4.14)
Hence the first two moments, mean and variance, of S(T) are:
[()] ()

[()]

()

)
72

To simulate this process, the continuous equation between discrete instants of time needs
to be solved as follows:

(

) (

)
(

)(

()

(4.15)
The following charts plot a number of simulated sample paths using the above equation for
different values of drift. The mean of the asset price grows exponentially with time.

Figure 4-6. GBM sample paths

Figure 4-7. GBM sample expectations (means)
73

4.1.3. Parameter estimation
This section describes how the GBM can be used as an attempt to model the random
behaviour of spot prices. In order for us to be able to model spot prices with GBM, negative
prices from historical data have to be removed (GBM can not be negative if set as positive).
There are only 8 days with negative prices and there prices are set to 1 /MWh. Spot price log
returns are shown in Figure 4-8.
The second chart (Figure 4-9.) plots the quintiles of the log return distribution against the
quintiles of the standard normal distribution. This QQ-plot allows one to compare
distributions and to check the assumption of normality. The quintiles of the historical
distribution are plotted on the Y-axis and the quintiles of the chosen modelling distribution on
the X-axis. If the comparison distribution provides a good fit to the historical returns, then the
QQ-plot approximates a straight line. In the case of the spot price log returns, the QQ-plot
show that the historical quintiles in the tail of the distribution are significantly larger
compared to the normal distribution. This is in line with the general observation about the
presence of fat tails in the return distribution of electricity prices. Therefore the GBM at best
provides only a rough approximation for the spot price. The next sections will outline some
extensions of the GBM that provide a better fit to the historical distribution.

Figure 4-8. Spot price log returns without 8 price negative days

74


Figure 4-9. QQ plot of spot price log returns
Having tested normality for the underlying historical data one can now proceed to calibrate
the parameters ( ) based on historical returns. To find that yields the best fit to the
historical dataset the method of maximum likelihood estimation is used (MLE). Let the log
return be given as:
MLE can be used for both continuous and discrete random variables. The basic concept of
MLE, as suggested by the name, is to find the parameter estimates for the assumed
probability density function

(continuous case) or probability mass function (discrete case)

that will maximise the likelihood or probability of having observed the given data sample x
1
,
x
2
, x
3
, ..., x
n
for the random vector X
1
, ...,X
n
. In other terms, the observed sample x
1
, x
2
, x
3
, ...,
x
n
is used inside (

), so that the only variable in f is , and the resulting

function is maximised in . The likelihood (or probability) of observing a particular data
sample, i.e. the likelihood function, will be denoted by ().
In the GBM case maximum likelihood estimation is done on log returns rather than on the
levels. By defining the X as:

(

) (

) (

)
(4.16)
The likelihood function is defined in general as:

()

(4.17)
75

The MLE estimate is found by maximising the likelihood function. Since the product of
density values could become very small, which would cause numerical problems with
handling such numbers, the likelihood function is usually converted to the log likelihood

. In this case the log-likelihood reads:

() [

)]

(4.18)
Probability density function is defined as (for GBM):

((

))

((
(

)
(

)
)(

))

The likelihood function needs to be maximised to obtain the optimal estimators

( ).
The natural logarithm of the likelihood function must be differentiated in terms of and
then equated to zero which will yield two equations and must be solved simultaneously to
obtain:

[

]


(4.19)
Where:

) (

(4.20)


(

(4.21)
First one needs to determine and then the MLE of GBM fitted to spot prices are:

As previously said, GBM does not fit well with historical spot prices, but same procedure
of parameter estimation can be used in other models. After determining the probability
density function and using MLE, parameters can be estimated by differentiating the likelihood
function in terms of process parameters. GBM can be used to independently model futures
76

prices, because futures price does not exhibit mean reverting behaviour and price spikes as do
spot prices.
4.1.4. Mean reverting processes
Process is considered to be mean reverting if with growing distance from the mean level,
increases the likelihood of returning to the mean level in the future. A simple example of a
mean reverting stochastic process S(t) is obtained as a solution of SDE defined as:

) ()
(4.22)
Where , ,

and are constants and () represents an increment to standard Brownian

motion W(t). The spot price S(t) will fluctuate randomly, but over the long run tends to revert
to some level . The speed of reversion is known as and the short-term standard deviation is
where both influence the reversion. This model is also known as Vasicek model, Gaussian
model or Ornstein-Uhlenbeck mean reverting process (OUMR).
Solving the Ornstein-Uhlenbeck Stochastic Differential Equation includes taking the
derivative of

() which yields:


(

(4.23)
Rearranging it:

(4.24)
Multiplying both sides of equation (4.22) with

to get:

()
(4.25)
By using equation (4.24) and substitute it into equation (4.25):

(

()
(4.26)
If an integral is taken from time t=0 to t it gives:

()

(4.27)

)
()
()

(4.28)

77

The solution of the stochastic differential equation (4.22) between s and t, if is:

()
(
()
)

()

(4.29)
Integral on the right hand side of equation (4.28) follows a normal distribution with a mean of
zero and a variance such that:

[(
()
()

] (
()
)

)
(4.30)
The conditional mean and variance of

given

is:

] (

(4.31)

)
(4.32)
If time increases the mean tends to the long-term value and the variance remains bounded,
implying mean reversion. The long-term distribution of the Ornstein-Uhlenbeck process is
stationary and is Gaussian with mean and variance

.
The discrete time version (which can be deduced by the Ito isometry) of this equation with
(assume constant for simplicity) time step t:

(4.33)
Where

is independent identically distributed and follows a standard normal distribution

with a mean of zero and a variance of one. After rewriting (4.33) to get:

(4.34)

(

)
(4.35)

(4.36)

(4.37)
78

The coefficients c, b and are calibrated using the equation (4.34). The calibration process is
simply an OLS (ordinary least squares) regression of the time series

on its lagged form

. The OLS regression provides the maximum likelihood estimator for the parameters c, b
and . By resolving the three equations system one gets the following a, and parameters:

()
(4.38)

( )
(4.39)

(

) ()
(4.40)
Applying equations above to fit historical spot prices following parameters of mean reverting
process are obtained (with ): (Figure 4-10.).

Figure 4-10. Mean reverting process fitted to historical spot prices
Distribution of simulated mean reverting prices, for 1000 simulations, fitted to historical data
is displayed in Figure 4-11. Distribution of daily returns has the same shape (varying from -
20% to 20%).
79


Figure 4-11. Distribution of 1000 simulated and fitted mean reverting prices
Figures above clearly illustrate that mean reverting process with a fixed mean (one-factor
mean reverting model) does not describe well the movement of prices on the spot market. If
we define the mean price as a separate stochastic process model (two-factor model) it will fit
historical data well, but we are left with many model parameters that need to be determined. If
we model mean price as a GBM we are using the Pilipovic model [15]:

() (4.41)

()
(4.42)

(4.43)
Deriving the conditional mean, variance and probability density function for two factor
mean reverting models is a complex task which goes beyond the scope of this paper. For more
information on the matter, please see [15].
For simulation purposes, two factor mean reverting model is used with a stochastic mean
modelled as a GBM. Figures from 4-12. to 4-14.

80


Figure 4-12. Mean reverting process with mean as GBM (red)

Figure 4-13. Distribution of 100 simulated mean reverting prices with mean as GBM

Figure 4-14. Distribution of 100 simulated mean reverting returns with mean as GBM
81

For simulation purposes we can also present a two factor mean reverting (MR) model with
a stochastic mean modelled as a separate mean reverting process with a fixed mean. Figure 4-
15. presents a MR model with a stochastic mean modelled as a separate MR process (Figure -
16.).

Figure 4-15. Mean reverting process with mean as a separate MR process

Figure 4-16. Separate mean reverting process corresponding to Figure 4-15.
82

4.1.5. Jump diffusion processes
Stochastic processes described so far include most of spot price characteristics other than
sudden jumps in price. By adding a jump process we obtain jump diffusion processes that are
very complex, have dozens of parameters and are hard to fit to the historical data.
The basic concept of random price movements used so far is normally distributed Wiener
process according to (4-8). To incorporate stochastic processes with jumps, an additional
concept of random price movements is required. Poisson process (PP) is used to model
jumps. Differential of PP is defined as:

{



(4.44)
Where is jump probability in time interval dt. Parameter represents the intensity of PP.
If we add jumps to two-factor mean reverting (MR) model with a stochastic mean modelled as
a separate mean reverting process with a fixed mean we acquire the following relations [13]:

()

(4.45)

() (4.46)
Where J represents a percentage amount of price change if a jump occurs ( ), which
can be modelled as a separate random variable. For simulation purposes and for simplicity
fixed values of J were taken. Simulation of MR process (blue) with jumps and mean as a
separate MR process (red) is displayed in Figure -17.

Figure 4-17. Simulation of two factor MR process with jumps
83

Deriving the conditional mean, variance and probability density function for two factor
mean reverting models with jumps is a very complex task which goes beyond the scope of
this paper. To compare with QQ plot of spot price log returns (Figure 4-9.) and distribution of
spot price daily returns (Figure 4-3.), following figures are displayed:

Figure 4-18. QQ plot of simulated spot price log returns (one simulation of 2370 days)

Figure 4-19. Distribution of simulated spot price returns (one simulation of 2370 days)
Both distribution and qq plot of simulated data show a good model fit with the historical
data. Fat tails, created by jumps, are well modelled and returns have a similar distribution
with heavy fat tails.

84

4.2. Derivatives modelling
Modelling electricity prices is a relatively young research area, but also the most
demanding one for analysis and implementation. Previously mentioned models of price
movements were originally used as simulation models for stocks, indices, interest rates, oil,
gas and other commodities on financial exchanges around the world. Electricity as a
commodity has a unique characteristic which no other traded commodity has, and that is the
impossibility of storage and delivery over a certain period instead of instantaneous delivery.
Modelling of spot prices shown in previous chapter, represents prices that are determined by
on day ahead auctions, a day before delivery. Determined daily price for the next day of
delivery says nothing about the price next week, month or year. Prices determined on day-
ahead auctions represent the price for distinct and separate goods that are delivered and
consumed the next day.
Future contract represents the average price of electricity to be delivered over a certain
period of time in future. For example, in the case of base futures contract, delivery will be
continuous during all hours of the day during the delivery period and the price of futures
contract will represent the same price for the entire delivery period. Since the underlying asset
of a futures contract is the daily price on spot market, the question emerges on how to connect
spot market prices with futures prices. A futures contract is traded for delivery in distant or
near future, while on spot market only delivery for one day in advance is traded. Absence of
spot market trading for delivery in the same delivery period of the futures contract makes
electricity exchange market incomplete, because it is very difficult to accurately link futures
price with the current spot price.
In practice, there are two approaches to stochastic modelling futures prices. The first
approach is that futures price is linked to the stochastic model of the spot market price
(section 4.1.). Another approach is to model futures prices separately as a separate stochastic
process. Separate modelling of futures prices is based on expectations of future movements in
electricity prices on the spot market. It can be modelled by a Brownian motion with a given
volatility and drift or with a stochastic volatility.
Options are written on futures contracts, and their premium depends on characteristics and
prices of futures contracts. On EEX exchange, final price at the end of each trading day is
determined by the Black 1976 formula (Fischer Black). Black 1976 is the formula for
85

calculating value of an option from price movements of a futures contract, while the Black-
Scholes formula uses prices from spot market as the underlying asset.
4.2.1. Modelling futures contracts
For modelling futures prices one should consider future/expected prices on the spot market
using the current price on the spot market. Futures contract price ( ) for delivery during
one day in the future can be expressed as [14]:

( ) ()
()

(4.47)
Where:
() electricity spot price at time t
risk-free rate (represents money that would be obtained if the money is put in
a bank instead of buying a futures contract)
T beginning of delivery period
Previous relation is based on no-arbitrage principle and is applicable only in financial
markets, while in commodity markets cost of storage - c needs to be added (Cost of carry), as
well as the privilege of holding goods - y(t). Electricity can not be stored, so only the privilege
of holding a futures contract is taken into account to obtain a relation:

( ) ()
(())()

(4.48)
Figure 4-20. presents spot prices (blue) and annual base futures contracts (red) with delivery
in 2015, during period from 2009 to 2014.

Figure 4-20. Spot price and price of an annual base futures contract with delivery in 2015
86

The price of a futures contract does not feature mean reversion as the spot price. For a
more accurate analysis of futures contract price it is better to use moving averages of the spot
price (Figure 4-4.). Relation (4.48) can be written as:
()
(
( )
()
)
( )
(4.49)

Figure 4-21. Ratio of spot price and futures price according to (4-49.) in case of spot price

Figure 4-22. Ratio of spot price and futures price according to (4-49.) with average spot price
87

In the case of S(t) being a real spot price, factor r-y(t) corresponding to Figure 4-19. is
shown in Figure 4-20. and on Figure 4-21., factor r-y(t) is shown where S(t) is a 30 day
moving average of spot prices.
From these figures it is clear that the privilege of holding a futures contract y(t), at a
constant rate, is a very volatile and unpredictable variable. The privilege of holding a contract
(or premium of a futures contract) is dependent on market situation and other fundamental
factors. Which is unfavourable, because futures contract premium is a variable on which price
dependence between spot and futures prices is based.
Relation (4-47.) is obtained by setting up a risk-free portfolio of spot prices and futures
prices with a condition that spot prices are modelled with GBM. With the same assumption of
a risk-free portfolio with spot prices modelled as a mean reverting process, which is modelled
as a GBM (Pilipovic model), a completely different dependence of spot and futures prices
emerges. As already mentioned before, spot price can not be modelled as a GBM, but it can
be modelled as a two-factor mean reverting process. Pilipovic model of spot price is defined
as [15]:

() (4.50)

()
(4.51)
After solving the SDE for S(t), applying a method of risk-free portfolio and several
approximations for futures price, the following expression is obtained [15]:

( ) (

()

()

(4.52)
Where:

(4.53)

(4.54)
speed of reversion to the mean level
drift coefficient
risk factor dependent on the volatility of the mean level
Figures 4-23. and 4-24. show the simulation of spot prices according to above mentioned
relations and prices of futures contracts with different values of risk factor . The price of a
futures contract will be higher or lower than spot price (average) depending on market
88

situation and expectations of market participant. The risk factor represents previously
mentioned premium of a futures contract, and it is clear that risk factor is a changing variable.
Pilipovic model with a constant represents futures price movements well.
All simulation processes, mentioned in previous section (4.1.), have an analytical solution
for the spot price S (t) and the price of a futures contract. The focus of this paper is to describe
simulation processes and characteristics of futures contracts, and less on mathematical
solutions of SDE to find a correlation between spot and futures prices.

Figure 4-23. Simulation of spot prices, average prices and futures prices with

Figure 4-24. Simulation of spot prices, average prices and futures prices with
89

So far, only relations for futures contracts with immediate delivery were discussed
(delivery period of one day ( )). Future contract price (

), where

is the
beginning and

the end of delivery period, is defined as:

(

( )

(4.55)
Separate modelling of futures prices can be modelled by a Geometric Brownian motion
with a given volatility and drift. To simulate this process, the continuous equation between
discrete instants of time needs to be solved as follows:

(

) (

)
(

)(

()

(4.56)
We will use historical prices of an annual base futures contract with scheduled delivery in
2015, which is displayed in Figure 4-20. in red colour. Figure 4-25. shows the distribution of
observed daily log returns on the futures market (blue) and normal distribution (red) with an
average value and standard deviation of the observed data.

Figure 4-25. Distribution of futures price daily log returns
After applying MLE for GBM to futures price historical data, the following parameters are
acquired (from section 4.1.3.):

With parameters above, fitted GBM curve was determined using a Monte Carlo simulation
with 10,000 iterations. Fitted futures prices are displayed in Figure 4-26.
90


Figure 4-26. Fitted simulation of futures prices using GBM
4.2.2. Modelling options
The best known solution for option premium valuation is definitely the Black-Scholes (BS)
model, largely due to its ease of use. BS model assumes that options underlying asset is the
spot price, which can be modelled by GBM (section 4.1.2.). Assuming that we can use
options to hedge and create a risk-free position in the spot market (risk-free portfolio) and
with other assumptions above, the BS differential equation for European option premium is
defined as [13]:

(4.57)
Where:
V option premium
t time
S spot price
volatility (annualized, standard deviation in %)
risk-free interest rate of the currency
A variation of the BS model is the so-called Black 76 model with futures prices as the
underlying asset, instead of spot price. EEX Exchange uses this model to evaluate premiums
[16], for example, to evaluate a Phelix option only movement of the underlying Phelix futures
91

contract is observed. Assuming that we can create a risk-free position on the futures market
by using options and assuming that futures/forward contracts do not require a large margin to
open and hold a position, the BS model becomes a Black 76 model defined as [13]:

(4.58)
Where F is the futures contract price. Solution of Black's model differential equation produces
known relations for premiums of call and put options written on futures contract.
Relation for European call option premium:


()
(

)
()
(

)
(4.59)
Relation for European put option premium:


()
(

)
()
(

)
(4.60)
Where:

( )


(4.61)

( )


(4.62)

(4.63)

()

(4.64)
From these relations it is clear that according to the Black model option premium is
analytical linked to the futures price. For example, the call option premium is: lower the
exercise price - K is higher, increasing if time to expiration (T-t) is higher, rising if futures
price is rising as well, increasing with higher volatility of the futures contract (not necessary if
the option is in the money). The same applies to the put option premium, except that its value
increases when the price of futures contract falls and when the exercise price is higher.
Relation (4.64) represents probability that a normally distributed variable will be less than x
(cumulative distribution function).
92

For simulation purposes interest rate r of 10% was taken, in order to better demonstrate the
impact of risk free interest rate on option premium. Current real value for risk-free interest
rate in the euro currency is from 0.5% to 1.5%. Value for volatility (annual) is assumed to be
constant and equals 20%.
With strike price K of 50 EUR/MWh, Figure 4-27. displays a simulation of call option
premium dependence on the price of futures contract, one year before the expiration of the
option (blue) and at option expiration (red). Figure 4-28. displays a simulation of put option
premium dependence on the price of futures contract also with K = 50 EUR/MWh. For
interest rate of 10%, option premium that has another year until expiration is less than the
option premium at expiration if option is about 10 euros or more in the money, or 10 euros
higher than the strike price for a call option or lower for a put option (60 euros for a call
option, around 40 euros for a put option). If interest rate is set to 0%, option premium that still
has time to expiration would always be higher or equal to option premium at expiry for all
futures contract prices. On all figures, premiums are denoted in euro currency.

Figure 4-27. Call option premium dependence on the price of futures contract


93


Figure 4-28. Put option premium dependence on the price of futures contract
With strike price K of 40 EUR/MWh and fixed futures contract price at 50 EUR/MWh (10
euros in the money), Figure 4-29. displays a simulation of call option premium dependence on
time until expiration, while Figure 4-30. displays call option dependence of an option that is
not in the money (K=60 EUR/MWh, F=50 EUR/MWh). With strike price K of 60 EUR/MWh
and fixed futures contract price at 50 EUR/MWh (10 euros in the money), Figure 4-31.
displays a simulation of put option premium dependence on time until expiration, while
Figure 4-32. displays put option dependence of an option that is not in the money (K=40
EUR/MWh, F=50 EUR/MWh). If interest rate were 0%, dependence curves would all have a
downward curve shape as an option that is not in the money (Figures 4-30. and 4-32.)

Figure 4-29. Simulation of call option premium that is in the money
94


Figure 4-30. Simulation of call option premium that is not in the money

Figure 4-31. Simulation of put option premium that is in the money
95


Figure 4-32. Simulation of put option premium that is not in the money
Combining together option premium dependence on futures price and time until expiration,
Figures 4-33. and 4-34. display call and put option dependence in 3D (with strike price K=50
EUR/MWh).

Figure 4-33. Call option premium dependence on futures price and time until expiration
96


Figure 4-34. Put option premium dependence on futures price and time until expiration
Using Pilipovic model for spot and futures prices from previous chapter, Figure 4-35.
shows an example of one spot and futures price simulation. With a targeted strike price K of
50 EUR/MWh, Figure 4-36. displays call and put option premiums written on simulated
futures contract from Figure 4-35. Figures from 4-34. to 4-36. show 10 simulations of
spot/futures prices and premiums of call and put options written on those futures contracts.

Figure 4-35. Pilipovic model spot and futures price simulation
97


Figure 4-36. Simulation of call and put option premium with strike price K=50

Figure 4-37. Ten simulations of Pilipovic model spot and futures price

Figure 4-38. Ten simulations of call option premium with strike price K=50
98


Figure 4-39. Ten simulations of put option premium with strike price K=50
4.2.3. Economic application of simulation models
Economic application of simulation models may have different goals in terms of structure
of electricity trading. Spot price simulation models are mainly used to hedge against price risk
by modelling future price movements based on historical data or expectations, or both.
Simulation of derivatives future price movements may also have other goals, such as arbitrage
and speculative trading, which in reality usually does not result in actual delivery of
electricity, due to possibility of exiting out of the position before the start of delivery period.
It is the reason why we saw an increased presence of financial institutions on power
exchanges in last few years. Of all three previously mentioned markets, largest recorder
trading volume is on futures market, because it combines all structures of trading, from
speculation to hedging.
For hedging purposes, modelling spot prices may determine business plans for market
participants in the near and/or distant future and its exposure to risk. From perspective of
electricity utility companies, who have agreed bilaterally to deliver electricity to large and
small consumers, it is important to determine the median price which they will receive from
their customers and from where and at what price will they acquire electricity. Assuming that
the utility company does not have bilateral agreements with electricity producers, electricity
should be acquired on the market. The spot market price can vary extremely from day to day,
and the utility provider must protect its self from extreme prices.
99

For utility company risk analysis, spot price simulation is performed with a two-factor MR
model with jumps (section 4.1.5.) and with 365 simulation steps where each step represents
one day. Assuming that utility provider bilaterally contracted median sales price of 70 /MWh
and that all electricity is purchased on the day-ahead spot market, Figure 4-40. shows the
distribution of daily earnings per MWh for 1000 simulations of price movements.

Figure 4-40. Simulated distribution of utility company daily earnings on the spot market
In risk management, widely used risk measure of the risk of loss on a specific portfolio or
financial assets is value at risk (VaR). Definition of VaR is: Value at Risk is an estimate, with
a given degree of confidence, of how much one can lose from ones portfolio over a given
time horizon. Common parameters for VaR are 1% and 5% (degree of confidence of 99% and
95%) probabilities and one day or two week horizons, although other combinations are in use.

Figure 4-41. QQ plot of utility company simulated daily earnings on the spot market
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In addition to price risk, utility company has exposure to load or demand of its customers.
By using stochastic processes in Chapter 4.1., load/demand can be modelled with ease and to
this end one-factor mean reverting process is the best choice. The assumption is that the
dealer has mostly large industrial customers whose plants are working all day at a relative
constant demand and the rest of customers are small consumers whose consumption varies
from day to day. We analysed only average daily demand, and within day demand is
considered to be balanced at no extra costs. Assuming average contracted load/demand of 100
MW, Figure 4-42. shows one simulation of load/demand.
Exposure to price risk of a utility company is relatively similar to price risk of a large
consumer, while producer price risk exposure is vice versa, because it has to be hedged from
low electricity prices. For utility company and producer, exposure to uncertain load is the
same. According to one-factor mean reverting simulation model it is clear that the main range
of demand movement is from 80 to 120 MW.

Figure 4-42. One simulation of load/demand with mean value of 100 MW
By purchasing an annual futures contract before the start of delivery period, utility
company fixes price for a certain delivery amount. Using spot price simulation example given
above and load simulation at the initial price on the spot market of 50 /MWh, the utility
company has bought 80 base annual futures contracts that will delivery constant power of 80
MW in each hour of the year. For example, it is assumed that futures contracts are purchased
at a price of 55 /MWh and that utility company bilaterally contracted median sales price of
70 /MWh, and that there is no correlation between spot market price and load/demand. In the
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event customer demand exceeds 80 MW, utility company will purchase additional electricity
that is needed, and if it is lower than 80 MW, utility company will sell excess electricity on
the spot market. In the event that utility company is not hedged with futures contracts,
profit/loss in one day can be expressed as:

(4.65)
In the event that utility company is hedged with futures contracts, profit/loss in one day is:

( ) (

) (

)] (4.66)

( ) (

) (

)] (4.67)
Where:

Simulated daily profit/loss.

B Bilaterally contracted median sales price (70 /MWh in this case).

Simulated daily spot price.

Simulated load/demand.

Hedged delivery amount with futures contracts (80 MW in this case).

F Contracted futures price (55 /MWh in this example).
If the load is equal to the agreed delivery amount with futures contracts, utility company
has a guaranteed profit of 15 /MWh (B-F). Load greater than contracted delivery requires a
purchase on the spot market, while utility company earnings are calculated by relation (4.66).
Utility company has a secure income contracted by futures contracts (left side of the equation)
and unknown earnings dependent on the current spot price and demand (right side of the
equation). Right side of the equation is positive if daily spot price is lower than bilaterally
agreed selling price, which may result in less profit for the company. If spot price is higher
than the agreed delivery price, utility company will have a negative business day if spot price
and demand are both high enough at the same time.
Relation (4.49) indicates the case when demand is lower than agreed delivery amount with
futures contracts and utility company has to sell excess electricity on the spot market.
Earnings equals a fixed amount (left side of the equation), dependent on load, and variable
earnings (right side) dependent on the load and difference between spot price and Contracted
futures price. In this case utility company has a surplus of electricity and thus tends to higher
prices on spot market in order to achieve higher profits when selling excess electricity.
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While Figure 4-40. shows the distribution of daily earnings per MWh, Figures 4-43. and 4-
44. display distribution of daily earning of utility company that is not hedged with futures
contracts (blue area). Red area represents 5% of possible outcomes and red line (Figure 4-43.)
represents Var value that separates the histogram on two areas. VaR of -18,500 represents
a minimum loss that will occur in one day out of 20 days (5% probability). In other words,
utility company (in this example) has a 95 % probability that it will not lose more than
-18,500 in one day. Figure 4-44. displays a 1% VaR, which equals -57,100 .

Figure 4-43. 5% VaR of simulated daily earnings on the spot market

Figure 4-44. 1% VaR of simulated daily earnings on the spot market
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Figure 4-45. shows simulated daily earning of an utility company with 1000 simulations of
spot price and load. Blue area represents the distribution of potential daily earnings if utility
company obtains all needed electricity on the spot market. The red area represents the
distribution of potential daily earnings if utility company is hedged against price risk with 80
futures contracts in this example (80 MW, average load 100 MW). Hedging advantages can
clearly be seen in narrowed distribution of possible daily earnings. By purchasing only on the
spot market, utility company has the possibility for very high daily profits of over 100 000,
but it also has the possibility for large losses over 50 000. If hedged, with 80 MW in this
case, possible daily earnings are mostly in range between 20 and 50 thousand , and if losses
occur they will be of small amount. Small losses are indicated by a positive 1% VaR.

Figure 4-45. Simulated daily earning of utility company (80 MW hedged)
Figure 4-46. represents the distribution of potential daily earnings if utility company is
hedged against price risk with 50 futures contracts in this example (50 MW, average load 100
MW). If hedged with only 50 futures contracts distribution is less narrowed, possible daily
earnings are in a wider range then with 80 futures contracts, losses will be more frequent and
if they occur they may be of larger amounts which is indicated by a 1% VaR of -10 000 .
A smaller range of expected daily earnings with a low probability of losses provides a
stable business perspective. More detailed business analysis and risk management can be
achieved by altering the contracted futures price, negotiated bilaterally mean price, spot price
and load process parameters.
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Figure 4-46. Simulated daily earning of utility company (50 MW hedged)
In simulation models only spot prices since the beginning of 2008 were considered, with a
highest recorded price of 130 /MWh. Before 2008, there were relatively frequent price jumps
over 200 /MWh, with a couple of jumps to levels above 800 /MWh (section 3.4). Jumps
can be relatively simply modelled by changing jump intensity, but the question is how to
hedge against sudden jumps on daily basis. On EEX exchange, futures contract are mostly
traded for delivery periods of one month, quarter and year, but delivery periods of one day,
weekend or week are also traded. Options are listed only on base Phelix contracts with
delivery periods of one month, quarter or year. Due to lack of options written on futures
contracts with shorter delivery periods or even daily options with spot electricity as the
underlying asset, it is not possible to use options to hedge against unexpected daily price
jumps.
Using futures contracts with longer delivery periods to cover most of the expected demand,
utility provider is exposed to the price risk when large or small demand occurs. Expecting a
higher or lower demand from customers, retailer can hedge against high/low prices on the
spot market by buying or selling the expected lack or excess of electricity through futures
contracts with delivery periods of one day, weekend or week (a few days/weeks before
delivery).
Options can be used to protect that part of delivery which is not covered with futures or
bilateral agreements when market participant has expectations of future price movements or
expectations about their business operations. For example, during winter periods utility
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company has expectations for strong demand from its customers in summer. Future contracts
for delivery in July are traded at 35 /MWh. The retailer is happy with the price, but in case of
large loads he wants to hedge against prices above 50 /MWh and decides to buy a call option
for delivery in July with exercise price of 50 /MWh and pays a premium of 0.1 /MWh. If
futures price finishes below 50 /MWh, retailer loses option premium, but if futures price
ends up above 50 /MWh, retailer will activate the option and buy futures contracts at 50
/MWh (total 50.1 /MWh with option premium). At any time before option expiration, if
futures price approaches or moves above the strike price, retailer can not activate the option
and buy futures contracts (European option), but he can sell it on the exchange to other market
participants and lock a profit before option expiration.
In case of electricity producers options can be used for realizing profits when prices on the
market are not high enough to cover production costs. For example, production company has
a power plant with production capacity of 25 MW and a production cost of 30 /MWh. Prices
on the spot market are currently below 30 /MWh on daily basis and futures price for next
month is 25 /MWh. The production company does not expect an increase in spot prices next
month and decided to sell 25 call options written on futures contracts with scheduled delivery
next month and strike price of 30 /MWh (equal to plant production costs). Company receives
a premium of 1 /MWh for selling options (for example). If futures price remains below 30
/MWh company has earned the received premium and it is not obliged to deliver anything,
but if futures prices end higher then 30 /MWh company must deliver electricity for that
month. Company has earned 1 /MWh (again) since their production costs are equal to the
money that they receive for delivering electricity.
Hedging several years in advance can be achieved by a combination of futures contracts
with different delivery periods, different beginnings of delivery and options written on them.
Buying or selling a futures contract on power exchange can be done only through margin
accounts. Margin for futures contract varies depending on current market situation, but
usually equals 5-10% of total contract value. Interest is charged on the residual value of a
futures contract, because residual is treated as borrowed money from a broker. Buying options
does not require margin and only premium has to be paid, but option premium increases with
option expiration time and can be very high for options which expiry in couple of years. On
the other hand, selling options requires margin which also varies depending market situation.
With all mentioned above we can conclude that hedging couple of years ahead is an expensive
process.
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The above example of hedging with futures assumed that the retailer bought futures
contracts just before beginning of delivery. In the event that retailer bought futures contracts
few months or years before beginning of delivery, interest that will be charged on residual
when holding an open position in futures contracts has to be taken into account. Buying the
entire delivery amount and holding futures contracts until the start of delivery is a classic
example of static hedging. In practice, the application of quantitative methods determines
lower amount of futures contracts (or options) that must be purchased to hedge equally well
against the risk of future price movements and thereby achieve savings on interest. In that
case we are talking about dynamic hedging. The problem of dynamic hedging is constant
monitoring of market situation, because optimal amount of futures contracts (or options) is
constantly changing with changing market trends.
In addition to hedging against the risk of future price movements directly on power
exchanges, protection can be applied across other exchanges where other products are traded
which are strongly correlated with the price of electricity. For example, gas and coal are
traded on EEX exchange and almost all financial exchanges around the world and they are
strongly correlated with electricity prices, because of their use as fuel in most power plants
today. By using quantitative methods and simulation processes it is possible to determine the
amount of positions in futures (or options) of gas or coal to protect the desired amount of
electricity delivery in the near or distant future. Ultimately, by incorporating many products
that are traded on various exchanges, the objective is to achieve as cheaper and safer
protection against the risk of future price movements.







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5. CONCLUSION
With lesser government influence, European power exchanges are seeing a steady increase
in market participants, liquidity and quality of products that are traded. Further development
of electric power infrastructure tends to higher level of market coupling in order to achieve
lower and more similar prices for different areas of delivery. By encouraging trade between
EU member states, the goal is to achieve a single market for trading products with delivery
areas in the euro zone.
In this paper, difference between mayor exchanges has been laid out. Largest European
power exchange (EEX) for delivery areas in Germany, Austria, Switzerland and France, was
taken as the reference exchange and structure of its spot and the derivatives market was
explained. Spot market is classified with two markets: day-ahead spot market, where trading
is based on auctions that are held one day before delivery, intraday spot market where trading
is conducted continuously and independently by market participants until few hours (or less)
before delivery. The derivatives market is organized as a market for futures contracts with
different beginnings and periods of delivery and options written on them. Future contracts are
traded for delivery periods from one day to one year, while options are written only on base
futures contracts with delivery periods of one month, quarter or year.
Historical prices from day-ahead spot market for German/Austrian delivery area (Phelix
area) were taken as referent prices and used to model stochastic processes that represent
electricity spot prices. Spot market is currently one of the most volatile markets in the world,
which makes spot price modelling and fitting with historical data a very difficult task.
Brownian motion stochastic processed were presented, but their use was determined
inappropriate for spot price modelling. The reason for this is a significant mean reverting
characteristic of spot prices, which Brownian motion processes do not posses. Instead mean
reverting processes were presented and from historical prices it was determined that the mean
level has to be a separate process as well. Modelling spot prices with two-factor mean
reverting processes (mean a changing variable), satisfactory overlap with historical data was
obtained. Due to the fact that electricity is a commodity that can not be stored, often in
unpredictable situations sudden jumps occur that push prices to extremely high or low
(negative) levels. In order to capture this characteristic, Poisson jump process is added to two-
factor mean reverting processes to obtain a relatively complete simulation model of the spot
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price. Jump intensity can be modelled as a separate function, whereas in this paper, fixed
values were taken for simplicity.
A futures contract is traded for delivery in distant or near future, while on spot market only
delivery for one day in advance is traded. Absence of spot market trading for delivery in the
same delivery period of the futures contract makes electricity exchange market incomplete,
because it is very difficult to accurately link futures price with the current spot price. Two
approaches to stochastic modelling of futures prices were presented: modelling futures prices
from spot price and separate modelling of futures prices. After presenting several models used
for spot prices, several methods of linking the futures price with the underlying average daily
spot price were presented. Presented methods are mostly used on financial and commodity
exchanges and are not applicable for power exchanges. Finally the Pilipovic model for
connecting spot and futures price was introduced. Analysis of futures price historical data
resulted in a conclusion that futures prices do not posses mean reverting behaviour or extreme
jumps. For this reason the price of futures contracts can be modelled as separate process of
Geometric Brownian Motion. Annual base futures contract with delivery in 2015 was
analysed, modelled (as GBM) and simulation process was fitted to the historical data. Options
are written on base futures contracts and their premium is determined based only on
characteristics and price movements of underlying futures contracts. To capture this strong
connection a well known Black 1976 formula for determining option premiums written on
futures contracts was used.
Whether we talk about a utility company, large consumer or producer, market participants
use simulation models to analyse their business and to hedge against risk. Due to missing load
historical data, load was modelled as a one-factor mean reverting model to show an example
of economic application of simulation models. To illustrate the importance of hedging, we
have presented a utility company, with bilaterally contracted customers, that obtains the
needed electricity on the exchange. Daily earning of the company, both hedged and unhedged,
were presented in a form of frequency distributions and widely used risk measure of the risk
of loss on a specific portfolio value at risk (VaR) was introduced. Several examples of option
usage were laid out as well. These examples of power derivatives usage indicate the
importance of futures contracts and options, and their increasing role in power exchange
functionality and development of electric power industry.


109

REFERENCES
[1] Chris Harris: Electricity Markets; Pricing, Structures and Economics, Wiley
Finance, 2006.
[2] EEX Italian Power Futures Milan workshop, Link:
http://documents.eex.com/document/149066/Presentation_EEX
[3] EEX report, Link:
http://www.eex.com/blob/68250/27b48c17c6925d18d84f5607d9a51d30/e-eex-
unternehmen-februar-2014-pdf-data.pdf
[4] Nord Pool Spot report, Link:
http://www.nordpoolspot.com/Global/Download%20Center/Annual-report/Nord-
Pool-Spot_Europe's-leading-power-markets.pdf
[5] http://www.apxgroup.com/wp-content/uploads/APX_map.jpg
[6] EPEX SPOT: current developments and projects, Link:
http://static.epexspot.com/document/27641/EPEX%20SPOT_EEX-
Workshop_05062014.pdf
[7] https://www.eex.com/en/about/eex/eex-group
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etreiber_neu.png
[9] https://www.epexspot.com/en/market-data
[10] Lessons from Liberalised Electricity Markets, International Energy Agency, 2005.
[11] http://www.transparency.eex.com/en/
[12] Rick ter Haar: On modelling the electricity futures curve, Twente University, 2010.
[13] Paul Wilmott: Paul Wilmott on Quantitative Finance, Wiley Finance, 2006.
[14] Alexander Eydeland, Krzysztof Wolyniec: Energy and Power, Risk Management,
Wiley Finance, 2003.
[15] Dragana Pilipovic: Energy Risk, Valuing and Managing Energy Derivatives, 2007.
[16] EEX Settlement Pricing Procedure, 2013.

110

SUMMARY
The first part describes the electricity market liberalization process and shows power
exchange functionality and products that are traded. Using EEX exchange as a reference,
electricity trade is explained through spot and derivatives market. Spot market is classified
with two markets: day-ahead spot market (auctions) and continuous intra-day spot market.
The derivatives market is organized as a market for futures contracts with different beginnings
and periods of delivery and options written on them.
The second part presents stochastic processes for modelling electricity price movements.
Defined processes are: Brownian motion, one and two factor-mean reverting processes and
Poisson jump process. Jump diffusion processes were obtained by combining a two-factor
mean reverting process with Poisson jumps and they had satisfying results in spot price
simulations. Futures prices were modelled through a connection with spot prices modelled by
Pilipovic model and through separate and independent modelling approach. Separate
modelling approach of futures prices was conducted through Geometric Brownian Motion and
was fitted to historical data. Option premium is defined through Black 1976 formula used for
calculating option premiums written on futures contracts. In the end, following previously
stated considerations, simulations were carried out in order to show few economic
applications of models, as well as futures contracts and options.