Additional Praise for Energy and Power Risk Management “Eydeland and Wolyniec give a very detailed, yet quite readable, presenta- tion of the risk management tools in energy markets. The book will be a valuable resource for anyone studying or participating in energy markets.” —Severin Borenstein E.T. Grether Professor of Business Administration and Public Policy, Haas School of Business, University of California, Berkeley Director, University of California Energy Institute “Activity in the power sector exposes all participants to complex and unique risk. Deregulation and the collapse of Enron have only increased the need to understand and control these risks. Covering the spectrum of risk and valu- ation, from the fundamentals of price movement and modeling with poor data, to physical asset valuation and the complex energy derivatives, this book offers a firm foundation from which to solve real world problems.” —Dr. Chris Harris General Manager, Commercial Operations, InnogyOne Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Aus- tralia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding. The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e- commerce, risk management, financial engineering, valuation and financial instrument analysis, as well as much more. For a list of available titles, please visit our web site at www.WileyFinance.com. Energy and Power Risk Management New Developments in Modeling, Pricing, and Hedging ALEXANDER EYDELAND KRZYSZTOF WOLYNIEC John Wiley & Sons, Inc. Copyright © 2003 by Alexander Eydeland and Krzysztof Wolyniec. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. 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For general information on our other products and services, or technical support, please contact our Customer Care Department within the United States at 800-762- 2974, outside the United States at 317-572-3993 or fax 317-572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data: Eydeland, Alexander. Energy and power risk management: new developments in modeling, pricing, and hedging / Alexander Eydeland, Krzysztof Wolyniec. p. cm. ISBN 0-471-10400-0 (cloth) 1. Energy industries—United States—Finance. 2. Portfolio management— United States. 3. Risk—United States. I. Wolyniec, Krzysztof. II. Title. HD9502.U52 E97 2003 333.79’068’1—dc21 2002013581 Printed in the United States of America 10987654321 To Alla, Becky, and Celia —A.E. To Alec and Ewan —K.W. Last H1 Head vii contents Introduction xi CHAPTER 1 Markets 1 CHAPTER 2 Basic Products and Structures 18 CHAPTER 3 Data 63 CHAPTER 4 Reduced-form Processes 118 CHAPTER 5 Forward Price Processes 198 CHAPTER 6 Correlation 211 CHAPTER 7 Hybrid Process for Power Prices 251 CHAPTER 8 Structured Products: Fuels and Other Commodities 306 CHAPTER 9 Power Plants and Other Cross-commodity Derivatives 384 CHAPTER 10 Risk Management 434 APPENDIX A Multidimensional Monte Carlo Simulation with a Given Volatility and Correlation Structure: The Case of GBM 461 APPENDIX B Optimization of Operations of Physical Assets 463 Bibliography 475 Index 483 vii acknowledgments e would like to express our gratitude to Boris Chibisov, Yan Gao, and WUriel Scott who have made conceptual contribution to this volume. Without their insights our understanding of the subject would have been significantly poorer. We would also like to thank our colleagues, Travis West, Dan Mahoney, Roman Kosecki, Harald Ullrich, and Tsvetan Stoy- anov, who have influenced our views on the risk management in energy mar- kets or contributed in other ways. Special thanks to Doug Tinkler, Sailesh Ramamurtie, Jay Catasein, Chris Hemschot, Mark Breese, and Vance Mullis for many stimulating discussions and to Eddie Anderson, Tim Kennedy, Jiri Hoogland, and Olaf Honerkamp for the assistance they have given to this project. We are particularly grateful to Holly Harkness for her expert help in preparing this book. Last but not least, we are thankful to Mirant Corp. for giving us an opportunity to witness firsthand the spectacular evolution of energy markets and for letting us use the historical data. Needless to say, the responsibility for all errors is solely ours. ix Last H1 Head xi introduction ew will argue that these are interesting times for the energy industry. FDeregulation of natural gas, initiated in the United States in the early 1990s, is slowly but inexorably moving into Europe and Asia. Simultane- ously, deregulation of the power industry, launched in Scandinavian coun- tries and continued in the United Kingdom and Australia, is taking root in North America. Introduction of the competitive natural gas markets in the United States and Canada has been an indisputable success from the point of view of liquidity, efficiency, and transparency. Power markets, on the other hand, are still too young to be judged with any degree of confidence. Due to geographical constraints and market idiosyncrasies their develop- ment has been, to say the least, uneven. The data thus far strongly argues that the effect of competition on power prices in general has been positive, manifesting itself in a substantial drop of wholesale prices in many regions. The failures, however, are also well known and publicized. Needless to say, the debate about competitive markets versus regulation still rages. We leave this fascinating topic outside the pages of our book—it is too big and too pe- ripheral to our subject. (It is worth noting, though, that in our opinion, the advantages of competition are beyond doubt.) The subject of this book is assessing and managing the risks of complex derivative structures arising in energy markets. It is natural to ask: Why do energy derivatives merit special attention and what is so unusual about them that we cannot use the familiar and well-developed risk management tools of the financial markets? Energy Derivatives Are Unique. A number of energy derivative products cannot be found in any other markets. For example, various volumetric op- tions, such as swing, recall, and nominational, which have been developed to manage risks associated with meeting the demand in natural gas or power, have no parallel in financial markets. Similarly exceptional are all kinds of load serving structures. To be sure, there are standard products—futures, forwards, swaps, options, but even they have unique features due to their predominantly physical nature. They settle differently and are defined dif- ferently. Even the commodities underlying these products are different. For example, electricity seems like a perfect commodity, since all electrons are naturally identical, but the impression is deceptive. Power delivered at any particular hour, block of hours, day, week, month, and so on, represents a xi xii INTRODUCTION different commodity because electricity cannot be stored and thus must be studied independently. Nonstorability of power is also a reason why most of the well-known financial theories may not be applicable to electricity deriv- atives. Finally, energy derivatives include structures whose complexity may surpass anything that one encounters elsewhere, namely, energy assets, such as power plants and gas storage. These assets are equivalent to a complex portfolio of options whose definition requires understanding of a great va- riety of economic, operational, environmental, regulatory, and other issues. Note that the complex features of