Mitigating hydrologic financial risk in hydropower generation using index-based financial instruments

Abstract

Variability in streamflows can lead to reduced generation from hydropower producers and result in reductions in revenues that can be financially disruptive. This link between hydrologic and financial uncertainties, and the possibility of increased hydrologic variability in the future, suggests that hydropower producers need to begin to consider new strategies and tools for managing these financial risks. This study uses an integrated hydro-economic model of the Roanoke River Basin to characterize the financial risk faced by hydropower generators as a result of hydrologic variability, and develops several index-based financial hedging contracts intended to mitigate this risk. Several different indices are evaluated in terms of their ability to serve as the basis for effective financial contracts. Contract structures are then developed and evaluated using a 100-year simulation that describes hydropower operations in the Roanoke basin. Basis risk, contract pricing, and risk mitigation are investigated for three styles of contracts: insurance, binary, and collar. In all three cases, the contracts are shown to be capable of substantially reducing the risks of very low revenue years for costs that are a small fraction of total annual revenues (1–3%).