Pricing Reliability Options under different electricity prices' regimes

TL;DR

This paper develops a mathematical framework for pricing Reliability Options in electricity markets, deriving closed-form formulas and analyzing their value through real-market data and sensitivity analyses.

Contribution

It provides the first comprehensive mathematical derivation of Reliability Options' pricing formulas and applies them to real Italian market data with detailed sensitivity analysis.

Findings

Closed-form pricing formulas derived for Reliability Options

Market calibration shows practical applicability of the formulas

Sensitivity analysis highlights key factors affecting option value

Abstract

Reliability Options are capacity remuneration mechanisms aimed at enhancing security of supply in electricity systems. They can be framed as call options on electricity sold by power producers to System Operators. This paper provides a comprehensive mathematical treatment of Reliability Options. Their value is first derived by means of closed-form pricing formulae, which are obtained under several assumptions about the dynamics of electricity prices and strike prices. Then, the value of the Reliability Option is simulated under a real-market calibration, using data of the Italian power market. We finally perform sensitivity analyses to highlight the impact of the level and volatility of both power and strike price, of the mean reversion speeds and of the correlation coefficient on the Reliability Options' value.