Applying mathematical finance tools to the competitive Nordic electricity market

Abstract

This thesis models competitive electricity markets using the methods of mathematical finance. Fundamental problems of finance are market price modelling, derivative pricing, and optimal portfolio selection. The same questions arise in competitive electricity markets.

The thesis presents an electricity spot price model based on the fundamental stochastic factors that affect electricity prices. The resulting price model has sound economic foundations, is able to explain spot market price movements, and offers a computationally efficient way of simulating spot prices.

The thesis shows that the connection between spot prices and electricity forward prices is nontrivial because electricity is a commodity that must be consumed immediately. Consequently, forward prices of different times are based on the supply-demand conditions at those times. This thesis introduces a statistical model that captures the main characteristics of observed forward price movements.

The thesis presents the pricing problems relating to the common Nordic electricity derivatives, as well as the pricing relations between electricity derivatives. The special characteristics of electricity make spot electricity market incomplete. The thesis assumes the existence of a risk-neutral martingale measure so that formal pricing results can be obtained.

Some concepts introduced in financial markets are directly usable in the electricity markets. The risk management application in this thesis uses a static optimal portfolio selection framework where Monte Carlo simulation provides quantitative results.

The application of mathematical finance requires careful consideration of the special characteristics of the electricity markets. Economic theory and reasoning have to be taken into account when constructing financial models in competitive electricity markets.