Dynamic Pricing of Peak Production

Peura, H and Bunn, D W (2015) Dynamic Pricing of Peak Production. Operations Research, 63 (6). pp. 1262-1279. ISSN 0030-364X

Abstract

Peak producers of nonstorable products, such as electricity, provide crucial flexible operating capacity to respond to infrequent and transient high demand periods. Faced with these uncertain revenue-earning opportunities, despite often having significant price-setting power, they need to profit from a limited number of pricing decisions in order to meet financial targets for viability. We study the repeated interaction between peak producers with a model that captures both the uncertainty in their short-term revenues and their market power. We investigate the conditions under which peak producers can implicitly coordinate to achieve high prices, under varying demand conditions. We analyze how financial objectives in the form of annual performance targets dynamically impact peakers’ pricing decisions, and the conditions under which setting such targets may benefit or hurt the owners of the firm. We further show how portfolio integration with lower marginal cost technologies can be an important factor in peak price setting, beyond the usual considerations of direct price externalities, capacity manipulation, or risk. These insights are useful not only in understanding how purely energy-based revenues can sustain the financial viability of peakers, and the dynamic emergence of price spikes, but also in providing the underlying process for pricing derivative contracts that policy makers may encourage or offer for resource adequacy.