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Valuation of energy storage: an optimal switching approach

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  • Rene Carmona
  • Michael Ludkovski

Abstract

We consider the valuation of energy storage facilities within the framework of stochastic control. Our two main examples are natural gas dome storage and hydroelectric pumped storage. Focusing on the timing flexibility aspect of the problem we construct an optimal switching model with inventory. Thus, the manager has a constrained compound American option on the inter-temporal spread of the commodity prices. Extending the methodology from Carmona and Ludkovski [Appl. Math. Finance, 2008], we then construct a robust numerical scheme based on Monte Carlo regressions. Our simulation method can handle a generic Markovian price model and easily incorporates many operational features and constraints. To overcome the main challenge of the path-dependent storage levels, two numerical approaches are proposed. The resulting scheme is compared with the traditional quasi-variational framework and illustrated with several concrete examples. We also consider related problems of interest, such as supply guarantees and mines management.

Suggested Citation

  • Rene Carmona & Michael Ludkovski, 2010. "Valuation of energy storage: an optimal switching approach," Quantitative Finance, Taylor & Francis Journals, vol. 10(4), pages 359-374.
    • Handle: RePEc:taf:quantf:v:10:y:2010:i:4:p:359-374
    DOI: 10.1080/14697680902946514
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    References listed on IDEAS

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    1. repec:dau:papers:123456789/607 is not listed on IDEAS
    2. Helyette Geman, 2005. "Commodities and Commodity Derivatives. Modeling and Pricing for Agriculturals, Metals and Energy," Post-Print halshs-00144182, HAL.
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