Risk Management in Electricity Markets: Hedging and Market Incompleteness

Abstract: The high volatility of electricity markets gives producers and retailers an incentive to hedge their exposure to electricity prices. This paper studies how welfare and investment incentives are affected when markets for derivatives are introduced, and to what extent this depends on market completeness. First, we show that aggregate welfare in the market increases with the number of derivatives offered. If firms have liquidity constraints, option markets are particularly attractive from a welfare point of view. Second, we demonstrate that increasing the number of derivatives improves investment decisions of small firms, because additional financial markets signal how firms can reduce overall sector risk. Finally, we show that government intervention may be needed, because private investors may not have the right incentives to create the optimal number of markets.