Market completeness: How options affect hedging and investments in the electricity sector

Bert Willems, J. Morbee

Research output: Contribution to journalArticleScientificpeer-review

Abstract

The high volatility of electricity markets gives producers and retailers an incentive to hedge their exposure to electricity prices by buying and selling derivatives. This paper studies how welfare and investment incentives are affected when an increasing number of derivatives are introduced. It develops an equilibrium model of the electricity market with risk averse firms and a set of traded financial products, more specifically: a forward contract and an increasing number of options. We first show that aggregate welfare (the sum of individual firms' utility) increases with the number of derivatives offered, although most of the benefits are captured with one to three options. Secondly, power plant investments typically increase because additional derivatives enable better hedging of investments. However, the availability of derivatives sometimes leads to ‘crowding-out’ of physical investments because firms’ limited risk-taking capabilities are being used to speculate on financial markets. Finally, we illustrate that players basing their investment decisions on risk-free probabilities inferred from market prices, may significantly overinvest when markets are not sufficiently complete
LanguageEnglish
Pages786-795
JournalEnergy Economics
Volume32
Issue number4
StatePublished - 2010

Fingerprint

Electricity
Derivatives
Sales
Power plants
Hedging
Market completeness
Electricity sector
Availability
Power markets
Electricity market

Cite this

@article{64002e5c6dc64f4c82399381415e1b29,
title = "Market completeness: How options affect hedging and investments in the electricity sector",
abstract = "The high volatility of electricity markets gives producers and retailers an incentive to hedge their exposure to electricity prices by buying and selling derivatives. This paper studies how welfare and investment incentives are affected when an increasing number of derivatives are introduced. It develops an equilibrium model of the electricity market with risk averse firms and a set of traded financial products, more specifically: a forward contract and an increasing number of options. We first show that aggregate welfare (the sum of individual firms' utility) increases with the number of derivatives offered, although most of the benefits are captured with one to three options. Secondly, power plant investments typically increase because additional derivatives enable better hedging of investments. However, the availability of derivatives sometimes leads to ‘crowding-out’ of physical investments because firms’ limited risk-taking capabilities are being used to speculate on financial markets. Finally, we illustrate that players basing their investment decisions on risk-free probabilities inferred from market prices, may significantly overinvest when markets are not sufficiently complete",
author = "Bert Willems and J. Morbee",
year = "2010",
language = "English",
volume = "32",
pages = "786--795",
journal = "Energy Economics",
issn = "0140-9883",
publisher = "Elsevier Science BV",
number = "4",

}

Market completeness : How options affect hedging and investments in the electricity sector. / Willems, Bert; Morbee, J.

In: Energy Economics, Vol. 32, No. 4, 2010, p. 786-795.

Research output: Contribution to journalArticleScientificpeer-review

TY - JOUR

T1 - Market completeness

T2 - Energy Economics

AU - Willems,Bert

AU - Morbee,J.

PY - 2010

Y1 - 2010

N2 - The high volatility of electricity markets gives producers and retailers an incentive to hedge their exposure to electricity prices by buying and selling derivatives. This paper studies how welfare and investment incentives are affected when an increasing number of derivatives are introduced. It develops an equilibrium model of the electricity market with risk averse firms and a set of traded financial products, more specifically: a forward contract and an increasing number of options. We first show that aggregate welfare (the sum of individual firms' utility) increases with the number of derivatives offered, although most of the benefits are captured with one to three options. Secondly, power plant investments typically increase because additional derivatives enable better hedging of investments. However, the availability of derivatives sometimes leads to ‘crowding-out’ of physical investments because firms’ limited risk-taking capabilities are being used to speculate on financial markets. Finally, we illustrate that players basing their investment decisions on risk-free probabilities inferred from market prices, may significantly overinvest when markets are not sufficiently complete

AB - The high volatility of electricity markets gives producers and retailers an incentive to hedge their exposure to electricity prices by buying and selling derivatives. This paper studies how welfare and investment incentives are affected when an increasing number of derivatives are introduced. It develops an equilibrium model of the electricity market with risk averse firms and a set of traded financial products, more specifically: a forward contract and an increasing number of options. We first show that aggregate welfare (the sum of individual firms' utility) increases with the number of derivatives offered, although most of the benefits are captured with one to three options. Secondly, power plant investments typically increase because additional derivatives enable better hedging of investments. However, the availability of derivatives sometimes leads to ‘crowding-out’ of physical investments because firms’ limited risk-taking capabilities are being used to speculate on financial markets. Finally, we illustrate that players basing their investment decisions on risk-free probabilities inferred from market prices, may significantly overinvest when markets are not sufficiently complete

M3 - Article

VL - 32

SP - 786

EP - 795

JO - Energy Economics

JF - Energy Economics

SN - 0140-9883

IS - 4

ER -