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Abstract
The joint uncertainties of wholesale price and end-user demand quantity often poses huge pricing challenges to energy retailers. However, the literature lacks analysis of such uncertainties’ impacts on retailer pricing behaviors and possible hedging behaviors. To study these impacts, this paper proposes four models: a risk-averse or a risk-neutral retailer deciding retail price with or without forward contract. We present closed-form solutions for these four models on optimal retail price, as well as optimal forward position (if allowed). We propose a novel approach of volatility decomposition to describe the relationship between behaviors and different volatility sources. Comparative statics gives detailed analysis of the pricing and hedging behaviors in both uncertainties, as well as their correlation. We obtain profit distributions using Monte Carlo simulations in the context of the California Electricity Market. Results show that the price and quantity uncertainties and their correlation create significant differences in the retailer’s behaviors, and the determinants of these differences are different. In addition, forward contract increases expected profit and decreases profit volatility for risk-averse retailers simultaneously. These results could serve as a benchmark for analyses of deregulated, imperfect energy markets coupled with contingent financial markets under both price and quantity uncertainties.
Highlights
Energy industries underwent a deregulation process that broke vertical integration into the wholesale market and the retail market [1]
4), we show that under a big price uncertainty and small quantity uncertainty, a risk-averse retailer without a forward contract will overprice a risk-averse retailer with a forward contract
To study the effects of price-quantity uncertainties and risk aversion on retailer’s pricing and hedging behaviors, we needed to examine the properties of the pricing r of our four models across the parametric dimension spaces, including quantity uncertainty σq, price uncertainty σp, and price-quantity correlation ρ
Summary
Energy industries underwent a deregulation process that broke vertical integration into the wholesale market and the retail market [1]. Quantity uncertainty is of great concern due to the difficulty in energy storage because massive storage along the energy supply chain is neither cost-effective nor flexible in response to fast-changing market conditions Under such complicated uncertainties, it is natural to expect that risk aversion could make a significant difference to a retailer’s pricing behavior. Given the general acceptance of hedging in an energy retailer, we are interested in studying the effect of price and quantity uncertainties, as well as the effect of hedging availability, on the price decision of a risk-averse retailer. These questions would be of great interest to producers, retailers, and consumers along the whole supply chain for the energy industry This paper addresses these questions by considering the following four models under the joint uncertainty case: 2. A risk-averse retailer that maximizes expected profit while minimizing variance by setting a retail price and hedging with forward contracts.
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