Abstract
The pay-off profiles of an option buyer or seller, indeed the risks they bear, are skewed and asymmetric by design. A poorly designed option has a tendency for inadequate or excessive risk mitigation. Our objective in this paper is to develop an optimisation model for determining the mix and structure of energy commodity options, given alternative levels of skew preference and option premium budgets. Our modelling is particularly suitable to the setting of electric utility regulation involving multiple stakeholders with potentially diverse skew preferences. A regulated electric utility has a fiduciary duty to seek a prudent programme for fuel cost hedging, yet various stakeholders, including but not limited to corporate managers, regulators, and consumer advocates, are able to influence its configuration. We implement calibrations and simulations of our model for scenarios pertaining to skew preference, option premium budgets, and a representation of a California regulatory incentive system. We assess the economic consequences of mischaracterising the concept of skew in the design of natural gas options.
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