Price Spikes

Price spikes occur because ultimately the demand for most energy products and
power in particular is inelastic. This means that once supply becomes scarce, prices
potentially need to rise to astronomical levels before there is a demand response. In
many cases consumers never see such price signals, meaning that prices could rise
to any level and they would continue consuming.
A major issue in the power market (and to a lesser extent in the other energy
markets) is that of price spikes within the spot market. These are of particular
concern for risk managers since they will blow through previously realistic Value-at-
Risk limits extremely quickly.
The ‘jump diffusion’ process provides some structure to capture this within a
quantitative structure. This requires three factors to estimate the impacts of spikes:
number, height and the duration. Traditionally, the three factors would be taken
from historical information, but risk managers may well want to change the factors
based on other fundamental analysis. For instance, simulation models can provide
an estimate of the likelihood of spikes based on the likelihood of supply shortages.
The duration of spikes can be problematical. Generally, spikes mean revert very
quickly. However, when prices go to extremely high levels liquidity and ‘shock’ factors
can see a significant widening of bid/ask spreads and leave prices ‘stranded’ at high
levels for some considerable time. Stress testing for different durations of spikes is
thus advisable when considering the maximum potential exposures.
An interesting affect of spikes is that you get very pronounced smile effects in
energy volatility. This is due to the fact that once prices rise above the normal levels
there may be no limit to the ultimate level. To take an example, say prices normally
range between $15/MWh and $40/MWh, occasionally moving up to $150/MWh.
When prices rise above $150/MWh you are beyond the ‘normal’ supply/demand
conditions. Given the inelastic demand, the probability of prices spiking to $5000/
MWh is similar to the probability of prices spiking to $500/MWh. Thus, while the
extrinsic value of a $100 call will be significantly lower than a $40 call; the extrinsic
value of $500 and $1000 calls may be very similar. When translating these back into
implied volatilities the result is very pronounced smile effects.