Behavioral pricing of energy swing options by stochastic bilevel optimization

Gross, P. & Pflug, G. ORCID: https://orcid.org/0000-0001-8215-3550 (2016). Behavioral pricing of energy swing options by stochastic bilevel optimization. Energy Systems 1-26. 10.1007/s12667-016-0190-z.

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Abstract

Holders of energy swing options are free to specify the amounts of energy to be delivered on short notice, paying a fixed price per unit delivered. Due to the complexity of potential demand patterns, risk elimination by replication of these contract at energy exchange markets is not possible. As a consequence, when selling delivery contracts, the energy producer has to explicitly consider the risk emanating from fluctuations in supply cost. The impact of these risk factors can be mitigated by the contract seller, who is an energy producer, to a certain extent: Supply cost fluctuations can be absorbed by the own generation portfolio whereas demand uncertainties can be influenced by the choice of the strike price, implicitly changing the buyer's behavior. Considering this, the determination of the optimal strike price can be formulated a a stochastic bilevel problem where the optimal decision of upper level player (price setting and production) depends on the optimal decision of a lower level player (demand depending on the price). We present a solution algorithm tailored to the resulting specific stochastic bilevel problem. We illstrate the effects of the behavioral pricing approach by studying behavioral price setting for natural gas swing options, highlighting in particulr the influence of the seller's production and contract portfolio as well as of the market liquidity on optimal exercise prices.

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