Volatility Skews Implied by a Multi-Technology Bid Stack Model for Electricity Markets

Abstract

This paper presents implied volatility smiles and skews for plain vanilla electricity options based on a new bid stack model developed in a previous paper. This underlying bid stack model for the electricity market is extended to the case of an arbitrary number N of technology classes embedded in the production stack (esp. for N>2). As bid stack model, the developed framework represents a structural model that considers a range of heat rates per technology class rather than a single heat rate. The electricity spot price S_{t} is considered as a function of random variables like residual load, available production capacity, as well as marginal production costs per technology class including the full technology switch dynamics. Additionally, deviations from the marginal cost price level in the form of a scarcity function are included. Presuming a stylised electricity market with three technologies (N=3), we apply closed formulas for European put and call options derived in the previous paper and exhibit the obtained volatility skew structures. Considering different electricity consumption regimes, the structural model approach reveals in a very transparent way, how the volatility skew features switch depending on the market's demand side.