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. (C) 2001 Elsevier Science B.V. All rights reserved.