Abstract
Short-term risk management is becoming increasingly significant in power trading as the intermittent renewable generators introduce more weather risk into the price formation dynamics. There is a vacuum in hedging instruments at the day-ahead stage to protect retailers in particular from such volatility and price spikes. Motivated by this requirement, this paper analyses a flexible hedging product, day-ahead cap futures. For pricing this product, we parametrically predict the probability distribution of day-ahead prices using the multifactor Generalized Additive Model for Location, Scale and Shape (GAMLSS) based upon the skew-t distribution with weather forecasts and calendar information as explanatory variables. In particular, we reveal that this higher-order moment model is superior to several lower-order models such as the normal distribution in all the following three aspects: fairness as pricing method, underwriting risk of the risk-taker and the variance reduction effect of the risk hedger.
Highlights
Hedging the spot price risk of commodities close to delivery is analytically challenging because of the special idiosyncrasies and fundamental factors which materialize when physical supply and demand are matched
We look at the design of a market product based upon an adaptation of day-ahead cap futures (DCF)† to hourly electricity prices, as an instrument to provide this protection, and we examine how it could be fairly priced
In Japan, there is a widely used hedging contract called ‘Joji Back-Up (JBU)’ which allows the retailers to procure next-day electricity at a fixed price from power generators (EMSC 2017), but there is an institutional motivation to look for more selective and flexible hedging instruments which would be especially appropriate for new entrants.§ We do not, in this research consider the design of an instrument to cap hourly prices risks as part of a government intervention, which may involve some kind of subsidy, but rather analyze whether a fair price can emerge from the market for such an instrument as offered by an intermediary, or negotiated between participants
Summary
Hedging the spot price risk of commodities close to delivery is analytically challenging because of the special idiosyncrasies and fundamental factors which materialize when physical supply and demand are matched. Close to delivery, for example, the distribution of spot prices will often exhibit changes in skewness and kurtosis, driven by weather conditions, sometimes flipping the sign of the skewness significantly (Gianfreda and Bunn 2018) Such a radical switch in the skewness can switch the balance of risk between producers and consumers. The most liquid wholesale electricity ‘spot’ markets worldwide tend to be the day-ahead auctions in which generators and retailers set prices for delivery at hourly intervals during the day. On the other side of the market, if a renewable generator had sold power under a forward contract and it was concerned about a drop in output because of the weather, it may be buying in the auction to fulfill its prior contract and could be concerned about a price spike In both these cases, a selective hedge against high prices in particular hours would be desirable.
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