The Efficiency of Network Transmission Rights
as Derivatives on Energy Supply Chains

Abstract

Electricity is a major energy commodity and, as with other commodities, numerous kinds of derivative contracts exist for future delivery. But the unique properties of electricity as an underlying make designing and valuing these derivatives very challenging. One consideration is that electricity is not storable; it must be “delivered” immediately, as soon as it is produced. This means that in order for a producer to deliver a quantity of electricity to a buyer, they must have already secured transmission rights on the appropriate grid. The technology of electricity production makes supply highly predictable, but demand fluctuates sharply, so the amount of “excess” electricity that is available is hard to predict. Contracts involving complicated types of optionality are common, suggesting that contracts for access to the transmission network may also involve complex optionality. Executing an electricity arbitrage trade across regions thus entails both forecasting the price differential and securing the transmission rights ahead of time. Bunn and Martoccia examine how transmission rights are priced for international arbitrage between the Netherlands and Germany and between Denmark and Germany. They show that it is not enough to think of the value of transmission rights only in terms of the expected price differential between two locations; it is also necessary to consider the optionality of the contracts.

TOPICS: Options, other real assets, developed