Modelling risk in energy contracts with investor owned generation

Investor owned generation capacity construction is being encouraged all over the world by both the current deregulatory climate and the need to defray the heavy capital demands of plant. Such schemes require contracts between investor and host utility on the price of electricity, and may include penalties for nondelivery, and compensation for failure to accept contracted energy. While it is widely appreciated that uncertainty of future conditions has an important bearing on what the terms of the contract should be, a theoretical framework for examining the influence of uncertainty has not, as yet, been developed for this problem. This paper proposes a theoretical model for linking the degree of future uncertainty, the expected production costs of investor plant and the expected production cost of host utility, with the electricity prices and penalty charges which are stipulated in the energy contract between the two parties. The insight gained from these mathematical models will be useful in contractual decision making