Integrating Real and Financial Options in Demand-Side Electricity Contracts

Shmuel S. Oren
University of California at Berkeley
Oren@IEOR.Berkeley.edu

Abstract
In a competitive electricity market traditional demand side management options offering customers curtailable service at reduced rates are replaced by voluntary customer responses to electricity spot prices. In this new environment, customers wishing to ensure a fixed electricity price while taking advantage of their flexibility to curtail loads can do so through a combination of operational plan and hedging instruments. This paper illustrates such integration of real and financial options by introducing a particular financial instrument referred to as a "double call". It is shown that a forward contract bundled with an appropriate double call option provides a "perfect hedge" for customers that can curtail loads in response to high spot prices and can mitigate their curtailment losses when the curtailment decision is made with sufficient lead time. As an illustrative exercise we also derive pricing and excercise policies for a double call option under the assumption that forward electricity prices behave as a geometric Brownian motion process.