Hedging Strategy and Electricity Contract Engineering - IFOR

4 Introduction
The uncertainty is however not necessarily negative for electricity producers.
As a matter of fact, flexible power plants can take advantage of volatile prices.
Traditional approaches to handle uncertainty in the electricity market was
focused on meeting a fluctuating load, where prices where assumed to be
deterministic. Since this is not the case anymore, a new approach to manage
risk in the electricity market is needed.
The liberalization of the electricity markets brings along a lot of risks for the
players, but also plenty of possibilities and chances. One of the keys to success
in the liberalized market is the ability to manage these new risks.
1.2. Goal and purpose
The goal of this thesis is to investigate risk management in the electricity market
in general and the interaction between physical production and financial
and physical contracts in particular. The focus of this work is on how an electricity
producer can utilize the operational flexibility in power plants as a risk
management tool.
1.3. Structure of the thesis
In Chapter 2 the electricity market in general is investigated. Its special characteristics,
which are needed as background for the further analysis, are highlighted.
In Chapter 3 some general risk management ideas are presented followed
by a short investigation of the risk measures currently used in the traditional
financial markets. After analyzing their suitability as risk measures
in the electricity market, the so-called Conditional Value at Risk is presented.
The chapter is closed by studying the traditional valuation techniques and their
shortcomings in the electricity market. In Chapter 4 the notion of contract engineering
is introduced and the set of contracts corresponding to each type of
power plant is systematically derived. The importance of flexibility in a power
plant is highlighted as a key value driver. In Chapter 5 some traditional hedging
strategies are introduced and once again the limitations of these traditional
approaches in the electricity market are pinpointed. Instead the concept of best