Hedging Strategy and Electricity Contract Engineering - IFOR

6.3 Power portfolio optimization in general 119
that the overall portfolio risk and expected profit depends on the dispatch
strategy. The dispatch will consequently influence the possibility to take
on risky positions in, for example, the contract portfolio. The dispatch
strategy of some plants will, maybe less obvious, depend on the contract
portfolio. The price risk would automatically be reasonably hedged by a
strategy like the gas turbine strategy, namely to produce when spot prices
exceed marginal costs. The volume risk, on the other hand, would not
be explicitly hedged by such a strategy, why the hydro dispatch strategy
would also be influenced by the volume risk in the portfolio, stemming
from swing options, interruptible contracts and stochastic outages of production
units.
Non-normality Whereas one often assumes that returns are normally distributed
in traditional financial markets, the return distribution of a power
portfolio will typically be non-normal and heavy tailed, for example,
caused by jumps in the spot price as described in Chapter 2.9. Naturally
a risk measure is needed that captures the non-normality of the return
distribution.
Probabilistic problems The last, but not the least difference to a traditional
financial portfolio is the fact that when modeling a production portfolio
consisting of hydro storage plants the available resource, water, is a
stochastic quantity. This calls for a probabilistic approach. For example,
the probability that the water level falls below zero must not exceed zero.
These aspects has to be captured by a power portfolio optimization approach
and we believe, as expressed already in Chapter 3.5, that CVaR is an appropriate
risk measure in the electricity industry, capturing the heavy-taildness of
electricity portfolios by penalizing large losses. Hence a portfolio optimization
based on CVaR seems suitable. In Chapter 3 two similar such portfolio optimization
approaches were introduced. In the first one, CVaR was minimized
under an expected profit constraint and in the second, the expected profit was
maximized under a CVaR constraint. Whereas the first approach was used for
finding the best hedge, we believe that the latter one is best suited for optimizing
a whole portfolio. The maximum risk level that may not be exceeded is
typically determined by the board. This risk level depends on the company’s
risk appetite, the company’s wanted credit rating and hence interest rate costs
and is typically fixed for longer periods of time. The goal to constantly be able
to utilize the given risk level naturally motivates the second approach, given by