Hedging Strategy and Electricity Contract Engineering - IFOR

50 Risk management
and typically also retailers are exposed to volume risk. Many electricity
contracts are still OTC and often tailored for each player. The liquidity of such
contracts is naturally extremely low. The liquidity problem in the electricity
markets is accentuated by the fact that there is not one global market, but
several regional markets as an effect of the finite transmission capacity and
the transmission losses. The liquidity consequently tends to be low relative to
traditional markets also for standardized contracts. The immature nature of the
electricity market as a deregulated market, where liquidity has not yet turned
to the exchanges, but where the majority of the transactions still are made on a
bilateral basis, makes it problematic to close a position fast. The liquidity risk
in the electricity market is hence substantial. The immaturity in combination
with complex contracts naturally also raises concern about the operational risk.
The electricity market faces at least the same risks as the traditional financial
market, whereas as mentioned the electricity market have had only a short time
to learn how to handle these risks.
One could of course add a number of new risks to the list, which is more on
a strategic level rather than on an operational level, such as technical risk. If
a new technology makes it possible to transmit electricity at a much lower
cost than today it would change the playground and markets would converge
towards one more global market. One result would be that inefficient producers
in high price markets would be out-performed by more efficient producers in
low price markets. We do however not see this as an issue for the risk manager,
but for the CEO and the board
Only price risk and volume risk are explicitly addressed in this work, even
though, for example, credit risk and liquidity risk naturally also are of great
concern to a player in the electricity market.
3.4. Traditional risk management models
Since the traditional financial markets have been exposed to financial risks for a
long time, the most sophisticated risk management models were developed for
these markets. The differences between the traditional financial markets and
the electricity markets are as already mentioned many, but studying these risk