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Optimal Static Hedging of Volumetric Risk in a Competitive Wholesale Electricity Market

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  • Yumi Oum

    (Pacific Gas and Electric Company, San Francisco, California 94105)

  • Shmuel S. Oren

    (Department of Industrial Engineering and Operations Research, University of California, Berkeley, Berkeley, California 94720)

Abstract

In competitive wholesale electricity markets, regulated load-serving entities (LSEs) and marketers with default service contracts have obligations to serve fluctuating load at predetermined fixed prices while meeting their obligation through combinations of long-term contracts, wholesale purchases, and self-generation that are subject to volatile prices or opportunity cost. Hence, their net profits are exposed to joint price and quantity risk, both of which are correlated with weather variations. In this paper, we develop a static hedging strategy for the LSE (or marketer) whose objective is to minimize a mean-variance utility function over net profit, subject to a self-financing constraint. Because quantity risk is nontraded, the hedge consists of a portfolio of price-based financial energy instruments, including a bond, forward contract, and a spectrum of European call and put options with various strike prices. The optimal hedging strategy is jointly optimized with respect to contracting time and the portfolio mix, which varies with contract timing, under specific price and quantity dynamics and the assumption that the hedging portfolio, which matures at the time of physical energy delivery, is purchased at a single point in time. Explicit analytical results are derived for the special case where price and quantity follow correlated Ito processes.

Suggested Citation

  • Yumi Oum & Shmuel S. Oren, 2010. "Optimal Static Hedging of Volumetric Risk in a Competitive Wholesale Electricity Market," Decision Analysis, INFORMS, vol. 7(1), pages 107-122, March.
    • Handle: RePEc:inm:ordeca:v:7:y:2010:i:1:p:107-122
    DOI: 10.1287/deca.1090.0167
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    1. Biggar, Darryl R. & Hesamzadeh, Mohammad Reza, 2022. "An integrated theory of dispatch and hedging in wholesale electric power markets," Energy Economics, Elsevier, vol. 112(C).
    2. Boroumand, Raphaël Homayoun & Goutte, Stéphane & Porcher, Simon & Porcher, Thomas, 2015. "Hedging strategies in energy markets: The case of electricity retailers," Energy Economics, Elsevier, vol. 51(C), pages 503-509.
    3. Janne Kettunen & Eissa Nematollahi & Yuriy Zinchenko, 2022. "Why do Energy Markets in Europe Rely on One Instrument?," Production and Operations Management, Production and Operations Management Society, vol. 31(4), pages 1473-1491, April.
    4. Matsumoto, Takuji & Yamada, Yuji, 2021. "Simultaneous hedging strategy for price and volume risks in electricity businesses using energy and weather derivatives1," Energy Economics, Elsevier, vol. 95(C).
    5. Boroumand, Raphaël-Homayoun & Goutte, Stéphane & Guesmi, Khaled & Porcher, Thomas, 2019. "Potential benefits of optimal intra-day electricity hedging for the environment: The perspective of electricity retailers," Energy Policy, Elsevier, vol. 132(C), pages 1120-1129.
    6. Tranberg, Bo & Hansen, Rasmus Thrane & Catania, Leopoldo, 2020. "Managing volumetric risk of long-term power purchase agreements," Energy Economics, Elsevier, vol. 85(C).
    7. Souhir, Ben Amor & Heni, Boubaker & Lotfi, Belkacem, 2019. "Price risk and hedging strategies in Nord Pool electricity market evidence with sector indexes," Energy Economics, Elsevier, vol. 80(C), pages 635-655.
    8. Hesamzadeh, Mohammad Reza & Biggar, Darryl R., 2021. "Generalized FTRs for hedging inter-nodal pricing risk," Energy Economics, Elsevier, vol. 94(C).
    9. Nicola Secomandi & Sunder Kekre, 2014. "Optimal Energy Procurement in Spot and Forward Markets," Manufacturing & Service Operations Management, INFORMS, vol. 16(2), pages 270-282, May.
    10. Johannes Kaufmann & Philipp Artur Kienscherf & Wolfgang Ketter, 2020. "Modeling and Managing Joint Price and Volumetric Risk for Volatile Electricity Portfolios," Energies, MDPI, vol. 13(14), pages 1-19, July.
    11. Alfredo Trespalacios & Lina M. Cortés & Javier Perote, 2021. "Modeling Electricity Price and Quantity Uncertainty: An Application for Hedging with Forward Contracts," Energies, MDPI, vol. 14(11), pages 1-26, June.
    12. Robert F. Bordley & Elena Katok & L. Robin Keller, 2010. "Honoring Michael H. Rothkopf's Legacy of Rigor and Relevance in Auction Theory: From the Editors," Decision Analysis, INFORMS, vol. 7(1), pages 1-4, March.
    13. Pankaj Pandey & Einar Snekkenes, 2016. "Using Financial Instruments to Transfer the Information Security Risks," Future Internet, MDPI, vol. 8(2), pages 1-62, May.
    14. Yuji Yamada & Takuji Matsumoto, 2023. "Construction of Mixed Derivatives Strategy for Wind Power Producers," Energies, MDPI, vol. 16(9), pages 1-26, April.
    15. Bell, Peter N, 2014. "The variance-minimizing hedge with put options," MPRA Paper 62156, University Library of Munich, Germany.
    16. Russo, Marianna & Bertsch, Valentin, 2020. "A looming revolution: Implications of self-generation for the risk exposure of retailers," Energy Economics, Elsevier, vol. 92(C).
    17. Bhattacharya, Saptarshi & Gupta, Aparna & Kar, Koushik & Owusu, Abena, 2020. "Risk management of renewable power producers from co-dependencies in cash flows," European Journal of Operational Research, Elsevier, vol. 283(3), pages 1081-1093.
    18. Peña, Juan Ignacio & Rodriguez, Rosa, 2018. "Default supply auctions in electricity markets: Challenges and proposals," Energy Policy, Elsevier, vol. 122(C), pages 142-151.
    19. Pircalabu, A. & Hvolby, T. & Jung, J. & Høg, E., 2017. "Joint price and volumetric risk in wind power trading: A copula approach," Energy Economics, Elsevier, vol. 62(C), pages 139-154.
    20. Takuji Matsumoto & Yuji Yamada, 2023. "Improving the Efficiency of Hedge Trading Using Higher-Order Standardized Weather Derivatives for Wind Power," Energies, MDPI, vol. 16(7), pages 1-22, March.
    21. Debbie Dupuis, Geneviève Gauthier, and Fréderic Godin, 2016. "Short-term Hedging for an Electricity Retailer," The Energy Journal, International Association for Energy Economics, vol. 0(Number 2).

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