Summary: This chapter reviews some of the essentials of electricity pricing. Electricity prices are strongly related to physical characteristics of a power system such as loads, meteorological conditions, fuel prices, unit operating characteristics, emission allowances, and transmission capability. Electricity has a distinct characteristic since it cannot be stored economically and transmission congestion may prevent free exchange of electricity among control areas. Thus, electricity price shows the greatest volatility among various commodities and if we simply utilize available algorithms used for forecasting prices of other commodities, we could expect fairly low accuracy.
The main driving forces that cause volatility in electricity prices such as load uncertainty, fuel price, and irregularity in hydro-electricity production, unplanned outages, constrained transmission (congestion), and market power are discussed in the chapter.
This chapter also discusses the major challenges to electricity derivatives, which include implementing reliable forward curves, inadequacy of existing price indices, basis risk, and inadequacy of traditional pricing models. The chapter presents a discussion on hedging tools for weather risk, volatility and risks involved with price forecasting, and a practical approach for calculating the short-term price of electricity.