Pricing and Hedging Electricity Supply Contracts: a Case with Tolling Agreements

Customized electric power contracts catering to specific business and risk management needs have gained increasing popularity among large energy firms in the restructured electricity industry. A tolling agreement (or, tolling contact) is one such example in which a contract buyer reserves the right to take the output of an underlying electricity generation asset by paying a predetermined premium to the asset owner. We propose a real options approach to value a tolling contract incorporating operational characteristics of the generation asset and contractual constraints. Dynamic programming and value function approximation by Monte Carlo based least-squares regression are employed to solve the valuation problem. The effects of different electricity price assumptions on the valuation of tolling contracts are examined. Based on the valuation model, we also propose a heuristic scheme for hedging tolling contracts and demonstrate the validity of the hedging scheme through numerical examples.