Risk hedging and competition : the case of electricity markets

The advent of retail competition in the energy industry was concomitant with the explicit emergence of energy suppliers.The latter buys electricity on the wholesale market or contractually from producers and resells it to its customers. The “textbook model” of competitive decentralized energy markets required the vertical separation of generation, retail, as well as network activities (transmission and distribution). Introducing competition at the retail level was thought to imply the emergence and development of “asset-light suppliers” who neither own generating nor distribution assets. By offering innovative retail contracts with attractive prices to electricity consumers, those suppliers were expected to generate a fierce price-competition (Hunt 2002; Hunt and Schuttleworth, 1997). However, in stark contrast to this theoretical vision, asset-light retail entry has never eventuated as expected. Asset-light suppliers bankrupted, left the market, were taken over, or evolved towards an integration into production in all retail markets. Departing from this unexpected market outcome, the paper compares hourly risk hedging portfolios for three European markets relying on hourly electricity volumes and price data. The paper is organized as follows: in section 2 we put forward the market risks faced by energy suppliers. Section 3 demonstrates the limits of financial hedging in liberalized electricity markets. Section 4 is devoted to comparing from numerical simulations the risk profiles of different hourly hedging portfolios’ made exclusively (or conjointly) of forwards, financial options, and/ or physical assets. The last section concludes and provides regulatory and policy recommendations. We demonstrate through a Monte Carlo simulation based on 6000 hourly electricity volume and price data, how portfolios can be optimized to reduce suppliers net revenue exposure. We use the Value at Risk (95%) and the CVAR to compare the risk profiles of the portfolios. Through the presented numerical simulations we provide evidence, that energy suppliers can hedge the market risks originating from their retail contracts by either a combination of forwards and options on the spot price or by a combination of forwards and physical assets. In all observed electricity markets, however, liquid derivatives on the spot market are absent (Geman, 2005; Hull, 2005). Thus, the only real choice for suppliers is to hedge their retail obligations through physical hedging (investing in electricity plants). These, however, might help to significantly reduce a supplier’s risk exposure. Consequently, as long as derivatives markets are not sufficiently liquid, suppliers will strive to vertically integrate to hedge their risk exposure. We also propose portfolio optimization based on intraday hedging of electricity intermediaries. Indeed, our results clearly demonstrate that the optimal hedging portfolio varies in relation with the hours of the day. First, our model demonstrates that the average of the cumulated hourly losses [as measured by the average VaR(95%)]of the seven homogeneous group of hours is lower than the VaR (95%) of a single daily optimal portfolio. Therefore, we propose several optimal hedging portfolios per day. Secondly, for any group of hours, we demonstrate that the optimal portfolio is specific. Conclusions and policy recommendations Our paper demonstrates that physical hedging, supported to some degree by forward contracting and spot transactions is an efficient and sustainable approach to risk management in decentralized electricity markets. In contrast to the theoretical premises, financial contracts are imperfect substitutes to vertical integration in the current market environment. The failure of asset-light electricity suppliers is indicative of the intrinsic incapacity of this organizational model to manage efficiently the combination of sourcing and selling risks. Vertically integrated, suppliers will maximize profits by relying on tacit price collusion in an oligopoly setting, which radically constrasts with the expected price competition envisioned in the reference market model of electricity liberalization. The role of competition auhthorities will therefore consist in stimulating competition between vertically integrated suppliers.