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Market completeness: How options affect hedging and investments in the electricity sector

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  • Willems, Bert
  • Morbee, Joris

Abstract

The high volatility of electricity markets gives producers and retailers an incentive to hedge their exposure to electricity prices by buying and selling derivatives. This paper studies how welfare and investment incentives are affected when an increasing number of derivatives are introduced. It develops an equilibrium model of the electricity market with risk averse firms and a set of traded financial products, more specifically: a forward contract and an increasing number of options. We first show that aggregate welfare (the sum of individual firms' utility) increases with the number of derivatives offered, although most of the benefits are captured with one to three options. Secondly, power plant investments typically increase because additional derivatives enable better hedging of investments. However, the availability of derivatives sometimes leads to 'crowding-out' of physical investments because firms' limited risk-taking capabilities are being used to speculate on financial markets. Finally, we illustrate that players basing their investment decisions on risk-free probabilities inferred from market prices, may significantly overinvest when markets are not sufficiently complete.

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Bibliographic Info

Article provided by Elsevier in its journal Energy Economics.

Volume (Year): 32 (2010)
Issue (Month): 4 (July)
Pages: 786-795

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Handle: RePEc:eee:eneeco:v:32:y:2010:i:4:p:786-795

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Web page: http://www.elsevier.com/locate/eneco

Related research

Keywords: Electricity markets Financial markets Market completeness Hedging Investments Options;

References

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  1. Jackwerth, Jens Carsten & Rubinstein, Mark, 1996. " Recovering Probability Distributions from Option Prices," Journal of Finance, American Finance Association, vol. 51(5), pages 1611-32, December.
  2. Palsson, Anne-Marie, 1996. "Does the degree of relative risk aversion vary with household characteristics?," Journal of Economic Psychology, Elsevier, vol. 17(6), pages 771-787, December.
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  8. Duffie, Darrell & Shafer, Wayne, 1985. "Equilibrium in incomplete markets: I : A basic model of generic existence," Journal of Mathematical Economics, Elsevier, vol. 14(3), pages 285-300, June.
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  10. Paul Willen, 2005. "New financial markets: who gains and who loses," Economic Theory, Springer, vol. 26(1), pages 141-166, 07.
  11. Duffie Darrell & Rahi Rohit, 1995. "Financial Market Innovation and Security Design: An Introduction," Journal of Economic Theory, Elsevier, vol. 65(1), pages 1-42, February.
  12. Duffie, Darrell & Shafer, Wayne, 1986. "Equilibrium in incomplete markets: II : Generic existence in stochastic economies," Journal of Mathematical Economics, Elsevier, vol. 15(3), pages 199-216, June.
  13. Milne, Frank & Shefrin, H. M., 1987. "Information and securities: A note on pareto dominance and the second best," Journal of Economic Theory, Elsevier, vol. 43(2), pages 314-328, December.
  14. Hart, Oliver D., 1975. "On the optimality of equilibrium when the market structure is incomplete," Journal of Economic Theory, Elsevier, vol. 11(3), pages 418-443, December.
  15. Gyutaeg Oh, 1996. "Some Results in the CAPM with Nontraded Endowments," Management Science, INFORMS, vol. 42(2), pages 286-293, February.
  16. Mark Rubinstein., 1994. "Implied Binomial Trees," Research Program in Finance Working Papers RPF-232, University of California at Berkeley.
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Cited by:
  1. Guy Meunier, 2013. "Risk aversion and technology mix in an electricity market," Working Papers hal-00906944, HAL.

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