Hedging and Tail Risk in Electricity Markets

A concern persistent in scarcity-based market designs for electricity over many years has been the illiquidity of markets for long-term contracts to hedge away volatile price exposures between generators and consumers. These missing markets have been attributed to a range of factors including retailer creditworthiness, market structure and the lack of demand side interest from consumers. Using a stochastic equilibrium model and insights from insurance theory, we demonstrate the inherent challenges of hedging a legacy thermal portfolio that is dominated by volatile fat-tailed commodities with significant tail dependence. Under such conditions the price required for generators to provide such hedges can be multiples of the expected value of prices. Our key insight is that when the real-world constraints of credit and financing are considered, the volatility of thermal fuels and their co-dependence under extremes may be a key reason as to why electricity markets have been incomplete in terms of long-term hedging contracts. Counterintuitively, in the context of the energy transition, our results show that, ceteris paribus, increasing the penetration of low carbon resources like wind, solar and energy storage, can add tail-diversity and improve contractability.

By: Farhad Billimoria , Jacob Mays , Rahmat Poudineh