Hedging tools in mitigating volatility of electricity prices: Pros and Cons

Author: Iloka Benneth Chiemelie

Published: 02 - December - 2014

Thanks for your post.

Hedging is the main point that interests me as you did highlight it to be the best approach for managing volatility in electricity prices. The fact is that participants in the wholesale electricity market have access to a number of potential hedging tools, but each of these tools have their own advantages and disadvantages. These tools are basically grouped into two as physical and financial tools. Sustainable Energy Advantage, LLC (2003) provided discussions on these solutions as below:

Physical hedging tools

Large-scale generation assets – they have the advantages of being a known source of power supply and ownership of this asset helps to mitigate volatility of electricity price as it does come with the advantage of being a known source of power output, fuel source and cost profile. Additionally, the own can decide when right to operate the tool, allowing for higher operation during profitable periods and reduce or no operation when costs are high.

Small-scale generation assets – this is the same as the large-scale generation asset and also offers the same benefits but it is mainly operated by individuals, families and small-scale firms as compared with the large-scale generation assets that are used by larger corporations.

Forward purchase of energy, or a forward contract – this is an energy trade in the form of agreement that is made between a buyer and a seller for the delivery of a given amount of energy at a specific location within a specific period in the future. Majority of these contracts are based on fixed price bases irrespective of change in time, thus allowing the buyer to mitigate volatility as it occurs.

Physical call and put options – this is an energy contract in which buyer and seller exchange the right, but not the responsibilities, to purchase (sell) a given amount of energy at a given location within a given time and at a specified strike price. This option can be used to mitigate volatility in price of electricity as it offers buyer a significant level of flexibility in hedging market price risk, without the need to commit to any given forward purchase.

Load curtailment – an ESCO or utility provider does have the ability to call customers to curtail their load (either through self-generation or curtailment of specific load). No matter the approach to curtailment, volatility in price of electricity can be mitigated through that process.

Financial hedging tools

Future contracts - Futures contracts are exchange-traded contracts for the delivery of a specific volume of energy at a specific location during a specific period in the future. In this sense, their hedging role is similar to forward contracts. It allows participants to mitigate volatility in electricity price as price doesn’t change with delivery.

Other options and financial call and put options, and contracts for difference. No matter the approach used, they all have the potential to mitigate price in electricity. In any case, there is a common disadvantage of a hedging and that is the fact that majority of the contracts have irrevocable price settings, which means that buyers (consumers) cannot be able to benefit from reduced price in future setting. Thus, this is a big question when it comes to adopting it as the right tool for mitigating volatility of electricity prices.

Reference

Sustainable Energy Advantage, LLC. (2003). Using Wind Power to Hedge Volatile Electricity Prices for Commercial and Industrial Customers in New York. Available at: file:///C:/Users/Hp-User/Downloads/using-wind-power-hedge-volatile-electricity-prices.pdf [Accessed on: 02-12-2014].