ABSTRACT
Summary: Competition in wholesale restructured electricity markets has created new financial and physical risks which could include price risk, volume risk, counterparty risk, and others. Even though a number of electricity risks are originated from sources that exist in other commodities as well, these sources could pose more severe consequences in electricity markets due to typical differences between electricity and other commodities such as non-storable nature of electricity and transmission flow implications.
In addition, risks associated with electricity markets would need more attention due to the fact that the electricity market, which is more than $200 billion per year, is one of the largest commodity markets in the United States. During the short period that electricity restructuring has undergone, many additional concerns have been magnified which are considered as wake-up calls for restructuring researchers and market participants. These concerns are essential in determining priorities when designing and implementing reliable and adequate hedging tools and hedging strategies for electricity markets.
The market experience in the past short period highlighted the issue of risks, especially the risk of counterparty default (i.e., failure to deliver on contract), implementation of weather-related derivatives in electricity markets, portfolio management, needs for accurate long-dated forward prices, and others. The lack of electricity market participants’ experience, especially hedgers’, with proper hedging tools for electricity has resulted in large trading errors at some locations in U.S. markets. These errors have occurred due to applying certain pricing models that would not 278consider the major differences between electricity and other commodities.
This chapter will discuss hedging issues in a restructured electric power industry. The chapter will present the major challenges for electricity market participants as they become involved in restructuring, give a detailed overview of sources of financial risks that could lead market participants to panic, give an overview of how players of energy markets could use electricity financial derivatives to hedge different risks. It will present the basic hedging tools in electricity markets, new derivatives that are especially created for electricity markets, types and sources of risks, and motive forces that could lead to risks in electricity markets. The chapter will discuss weather-related derivatives. In addition, the Midwest crisis of June 1998 — the unforgettable mark in the U.S. electric industries — will be addressed to exhibit the importance of hedging in electricity markets. It will show various shortcomings in the electricity derivatives pricing model. Moreover, it will present illustrative examples for implementing hedging tools.
