Optimal sequencing of hydroelectric and thermal power generation under energy price uncertainty and demand fluctuations

Abstract

The choice between hydro and thermal power in electricity supply is analyzed under stochastic demand and stochastic fuel cost. The first formulation gives rise to an optimal stopping problem, where the investment in hydro power is not undertaken until the price of natural gas reaches a reservation price. Since investment in hydro power is irreversible, the thermal source should be utilized until the the reservation price is reached, and this reservation price is higher under uncertainty. The second formulation gives rise to a stochastic control problem. In this solution there is an expansion of the hydro power system over time, with investments taking place whenever the random component of demand reaches a boundary. We suggest applications to current problems in the Norwegian energy sector.