Hedging Strategy and Electricity Contract Engineering - IFOR

7.3 Hedging value of water 181
The average price of produced electricity lies between 39.8 CHF/MWh for
a tight risk constraint and 45.2 CHF/MWh for a loose risk constraint. The
dispatch strategy is obviously more focused on selling at a high price when the
risk is not an issue, whereas when the risk is tightly constrained the strategy
tries, not only to fulfill the implicit goal of selling the electricity at a high
price, but also to keep the risk below an acceptable level. The optimal strategy
responds in two ways to cope with a tight risk constraint, through both the
contract portfolio and the production portfolio. Firstly, the spot position
is decreased through a reduced future position, resulting in a diminished
gross position of the portfolio and secondly, the dispatch is more focused on
decreasing the risk.
The flexibility of the hydro storage plant is, as described in Chapter 6.6.8,
partially demonstrated by the difference between the average price of produced
electricity and the average spot price. The excess price of produced electricity
over the average spot price S h S decreases with a tighter risk constraint,
since the dispatch strategy is forced to handle the risk, which consequently
limit the production flexibility. Still, the produced electricity is on average
always sold at a higher price than the average spot price, as seen in Figure 7.5.
The excellent hedging performance, i. e. risk reducing capabilities of the
hydro storage plant as a result of its great flexibility is however not visible in
Figure 7.5. If we study the marginal value of water in the dam, i. e. the dual
price of the constraint on the end water level, this outstanding risk management
potential becomes apparent. We have plotted this marginal value of water
together with the average price of produced electricity as a function of the
risk constraint in Figure 7.6. Obviously, for tight risk constraints an extra unit
of water is assessed far higher than the value that water on average has on
the market, given the chosen dispatch strategy. The difference can be rather
substantial. For an optimal portfolio with a maximum risk of -2 million CHF,
the marginal value of water is 48% higher than the average price of produced
electricity. For tighter risk constraint the difference becomes even greater.
On the other hand, when the risk constraint is relaxed the difference almost
disappears and for the pure maximization problem the hedging value of water
is slightly negative, which is consistent with Proposition 6.5. Logically the
marginal value of water should decrease with a looser risk constraint. As the
risk constraint becomes non-binding the problem is transformed into a pure