Hedging Strategy and Electricity Contract Engineering - IFOR

Chapter 1
Introduction
1.1. Motivation
The electricity market in Europe is going trough a big transition. From being
a regulated market with no or very low uncertainty in future earnings, the
market is now becoming liberalized and deregulated. Electricity prices are no
longer determined by the regulator, but by the market. From the deregulated
markets in, for example, California, Sweden and Norway, one has observed
extremely volatile prices. For an electricity producing company this makes
future earnings very uncertain and brings along a need for risk management.
Electricity can be traded in a similar manner as stocks at power exchanges in,
for example, Germany and Scandinavia. There are however major differences
between the traditional financial markets, such as the stock market, and the
electricity market, like lacking liquidity, tremendous volatility, non-normal
distributions, real option pricing problems and market incompleteness. The
electricity market especially distinguishes itself by the transmission constraints
and the non-storability of electricity. Because of the specific characteristics
of electricity, like price jumps and the fact that producing companies are
by nature long in electricity, the risk management ideas developed for the
financial markets are not directly applicable to the electricity market.