Hedging Strategy and Electricity Contract Engineering - IFOR

3.3 The risks in the electricity market 49
Cross commodity price risk - the risk that the price relationship of electricity
to other commodities, such as natural gas or aluminum will
change.
Cash/futures basis risk - the risk of the price of the futures contract deviating
from the physical market price of electricity for the same time
period. The lack of convergence between cash and futures contracts
can be caused by an illiquid market.
Physical risk - the risk that electricity is not physically delivered or received
as agreed due to capacity constraints or production and delivery problems.
The economic effect to a chemical industry, for example, of an outage can
be huge. An interrupted chemical process may have to be totally restarted
with severe consequences on the production as a result. The value of
lost load can exceed 75 $/kWh [WH97] to be compared with a typical
electricity price of a few cents.
Regulatory risk - changes in value due to unexpected regulatory intervention.
Examples of such interventions are the two-year price cap enforced 1994
in UK and the changed price cap from 250 $/MWh to 700 $/MWh in
North Carolina in 1999.
Political risk - changes in value due to unexpected political decisions. The
decision in 1999 to close down one nuclear reactor in Sweden is an example
of such a political decision that affected the whole market. The
long planning horizons of the electricity industry, like 30 to 40 years,
mean that industry life cycles are much longer that the length of a government
in office. Political uncertainty relates to the uncertain implications
of changes in the government or policy legislation.
The five first risks; price-, credit-, settlement-, liquidity- and operational-risk
are familiar from the financial markets. However, because of the highly
volatile electricity prices, the price risk and hence also the credit risk can be
argued to be even more severe in the electricity market. One could also argue
that the basis risks are nothing but price risk for the whole portfolio. The
physical-, regulatory-, and political-risk are, as we see it, far less important in
the traditional financial market than in the electricity market today. Volume
risk does not exist in the traditional financial markets, but as we know from
Chapter 2.5 electricity end-users have a very variable consumption, why they