Abstract
In the discussion on the relationship between spot and forward prices in electricity markets, the equilibrium approach has an unambiguous prevalence. It is the relative recency of this market that gives rise to the question of how precisely forward prices converge to the spot prices. We decide to measure this convergence, with its eventual imbalance called risk premium, on several European energy exchanges trading electricity futures. The concept of risk premium, as it is worked out by Bessembinder and Lemon (2002) is reviewed in our essay through the Markowitz portfolio theory. Unlike in the B-L model, where the variance of the spot price has a strictly negative relationship to the risk premium, it is shown that the portfolio theory gives us a different inference that the variance can have both negative and positive impacts according to the strength of supply and demand in the market. This empirically tested and found appropriate. Positive dependence of variance in the electricity markets have been found in Central Europe and Scandinavia, while in Iberian the results are still negative.
Highlights
The deregulation of electricity markets throughout the developed world has triggered a new perception of the electricity sector among the entities concerned
The only exception is the NordPool data set, where the linear relation between variance and the observed risk premium is statistically significant in confidence 1% level and negative, what is in compliance with original assumption of B-L equilibrium model
We look at the behavior of forward risk premiums on four European exchange markets trading electricity futures
Summary
The deregulation of electricity markets throughout the developed world has triggered a new perception of the electricity sector among the entities concerned. In order to stabilize their profits, they turn attention to forward electricity markets with various negotiable instruments to hedge their positions . We aim to look closer at these forward markets and examine whether one can take the futures’ quotations as estimates for the spot prices, or rather, these reflect the market equilibrium of supply and demand for hedging instruments. We provide theoretical background of the risk premium, and using empirical data from selected European power exchanges investigate what shapes its values. The third subsection goes on by applying the portfolio theory on electricity market and its participants.
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