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CEIC-06-03

"An options theory method to value Electricity Financial Transmission Rights"

Dalia Patiño-Echeverri and Benoit Morel

Abstract:
In deregulated electricity markets, members of today’s electricity industry face financial risks that either did not exist or were not so significant in the former days of vertically integrated utilities. One example of these risks is the one associated to transmission congestion costs, which can be hedged with Financial Transmission Rights (FTRs).

Evidence that in the auction of annual FTRs in PJM, clearing prices included a “risk-premium” that “hedgers” paid to reduce the risk of highly volatile congestion charges, and “insurers” charged for bearing this risk, confirms the idea that hedging comes always at a cost, and motivates the questions of 1) how to find the value of these hedging instruments and 2) how efficient are the markets where these are traded.

The valuation of hedging instruments like FTRs posses a challenge because traditional methods to value financial derivatives do not directly apply. In this paper we extend the paradigm of options valuation to 1) Present, and apply a formula for the “fair value” of the premium of the FTR based on the probability distribution function of the corresponding Congestion Charges. 2) Argue that in PJM the lack of competition among insurers and the competition among hedgers increases the premium received by the former ones and paid by the others. 3) Argue that in PJM the higher the number of transactions for the same Point-to-point combination, the higher the premium paid by hedgers and received by insurers.

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