Oxford – Hedging and Tail Risk in Electricity Markets

For many years, one of the main concerns in electricity markets has been the lack of long-term contracts to hedging against volatile price exposures. This lack of hedging markets has been attributed to various factors such as retailer creditworthiness and the structure of the market. The authors of this paper use a stochastic equilibrium model and insights from insurance theory to demonstrate the challenges of hedging a legacy thermal portfolio with volatile fat-tailed commodities and significant tail dependence. They found that in such conditions, the price required for generators to offer hedges can be much higher than expected. The authors suggest that the volatility and co-dependence of thermal fuels under extreme conditions may be a reason why electricity markets have been incomplete in terms of long-term hedging contracts. Interestingly, the study shows that increasing the penetration of low carbon resources like wind, solar, and energy storage can improve contractability by adding tail-diversity.