Pricing the hidden options in power contracts: a case with tolling agreements

Abstract

Customized electric power contracts catering to specific business and risk management needs prevail among large energy firms. A tolling agreement is one such example in which the purchasing party (buyer) has the right to operate a power plant by paying a predetermined rent to the owner of the power plant. In addition, the buyer receives either the physical electricity by running self-supplied generating fuel through the plant or the financial settlement equalling the spread between the electricity price and the heat rate adjusted fuel price by simultaneously selling electricity and purchasing fuel in the market. An option pricing approach is proposed to value the tolling contracts incorporating major operating characteristics and contractual constraints. Dynamic programming (DP) and the Monte Carlo based least square approximation of the DP value function are employed in solving the problem. The effects of different power price models on the valuation of tolling contracts are examined as well.