Integrating real and financial options in demand-side electricity contracts

In a competitive electricity market traditional demand-side management (DSM) 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 by purchasing a forward electricity contract bundled with a financial option that provides a hedge against price risk and reflects the ‘real options’ available to the customer. This paper describes a particular financial instrument referred to as a ‘double-call’ option and derives the value of that option under the assumption that forward electricity prices behave as a geometric Brownian motion process. It is shown that a forward contract bundled with an appropriate double-call option provides a ‘Perfect hedge’ for customers, which 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.