Hedging Strategy and Electricity Contract Engineering - IFOR

74 Risk management
3.8. Summary
The complex contracts, the limited liquidity, the immaturity of the market and
the highly volatile prices makes the electricity market risky. Managing risks is
of great importance in general and in the risky electricity market in particular,
in order to decrease costs and to avoid losses and bankruptcy. Because of the
special characteristics of electricity and the differences to traditional financial
markets, a new risk measure is needed. We believe that CVaR is an appropriate
risk measure in the electricity market and the utilization of CVaR can be
optimized with linear programming. Pricing of electricity contingent claims
is a challenging task and today there exists no operational pricing models that
rely on a sound theoretical base, where the special characteristics of electricity
is taken into account. Instead, the industry uses more or less motivated models
to price their books. It is beyond the scope of this work to go further into
pricing, but in the following chapter we will show how electricity derivatives
can be replicated by physical assets and assessed internally.