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Risk management in electricity markets: hedging and market incompleteness

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  • Bert Willems
  • Joris Morbee

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 markets for derivatives are introduced, and to what extent this depends on market completeness. We develop an equilibrium model of the electricity market with risk-averse firms and a set of traded financial products, more specifically: forwards and an increasing number of options. Using this model, we first show that aggregate welfare in the market increases with the number of derivatives offered. If firms are concerned with large negative shocks to their profitability due to liquidity constraints, option markets are particularly attractive from a welfare point of view. Secondly, we demonstrate that increasing the number of derivatives improves investment decisions of small firms (especially when firms are risk-averse), because the additional financial markets signal to firms how they can reduce the overall sector risk. Also the information content of prices increases: the quality of investment decisions based on risk-free probabilities, inferred from market prices, improves as markets become more complete Finally, we show that government intervention may be needed, because private investors may not have the right incentives to create the optimal number of markets.

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Paper provided by Katholieke Universiteit Leuven, Centrum voor Economische Studiën in its series Center for Economic Studies - Discussion papers with number ces0823.

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Date of creation: Aug 2008
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Handle: RePEc:ete:ceswps:ces0823

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Cited by:
  1. van der Weijde, A.H. & Hobbs, B.F., 2011. "Planning electricity transmission to accommodate renewables: Using two-stage programming to evaluate flexibility and the cost of disregarding uncertainty," Cambridge Working Papers in Economics 1113, Faculty of Economics, University of Cambridge.
  2. Willems, Bert & De Corte, Emmanuel, 2008. "Market power mitigation by regulating contract portfolio risk," Energy Policy, Elsevier, vol. 36(10), pages 3787-3796, October.

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