Exotic Options for Interruptible Electricity Supply Contracts

Abstract

This paper presents the design and pricing of financial contracts for the supply and procurement of interruptible electricity service. While the contract forms and pricing methodology have broader applications, the focus of this work is on electricity market applications, which motivate the contract structures and price process assumptions. In particular, we propose a new contract form that bundles simple forwards with exotic call options that have two exercise points with different strike prices. Such options allow hedging and valuation of supply curtailment risk, while explicitly accounting for the notification lead time before curtailment. The proposed instruments are priced under the traditional GBM price process assumption and under the more realistic assumption (for electricity markets) of a mean reverting price process with jumps. The latter results employ state-of-the-art Fourier transforms techniques.