Hedging Strategy and Electricity Contract Engineering - IFOR

126 Power portfolio optimization
A similar argumentation can be conducted for the improbable, but possible
case of negative prices. Hence we have shown by contradiction that (6.8)
will hold in optimum, why we will not explicitly require that pumping is not
conducted simultaneously with production.
Even though the static dispatch strategy is naive in the sense that it does not
respond to new information and fails to capture the option features of the hydro
storage plant, it is illustrative to understand the value of a hydro plant. Further,
it serves as an introduction to the dynamic dispatch strategy, which will
be introduced in the next section. By modeling the inflow as deterministic, for
example as the average inflow, there is a way to theoretically lock in the future
earnings, i. e. to fully hedge the stochastic cash flows stemming from the hydro
storage plant. The strategy is to sell the known, but time-varying water in the
dam in the electricity futures market. In order to be able to replicate the hourly
future positions x f Ü
áaá@á
1
x f K with the dispatch, it is obvious that x k x f
k
has to
solve (6.2), (6.5) and (6.7). Given that the inflow actually would be deterministic,
such static dispatch strategy would be the one chosen by an extremely Ü risk
averse utility with no other exposures, since the price risk would be perfectly
hedged away. Such a utility, however still naturally wants to maximize these
deterministic cash flows. How this is done is shown later in Chapter 6.6.3.
6.4.5.2. Dynamic dispatch strategy
In the static dispatch approach the production schedule over the whole period
is determined today and is fixed. We know that the hydro storage plant
in contract terms is a series of interdependent options and not a series of
interdependent futures. The value of an option, contrary to a future, comes
from the fact that one does not have to make the decision in advance whether
to exercise it or not, as a result a true asymmetric payoff is achieved. Our static
modeling of the hydro plant cannot capture the value of this flexibility. The
model does not react to, for example, a high price in a certain period. Instead
if a high price was not probable the schedule could have been to actually pump
in that period, which naturally would be counterproductive.
To capture the value of the flexibility and to be able to fulfill the tighter, but
realistic constraints that had to be relaxed for the static dispatch strategy