Risk Management in Electricity Markets: Hedging and Market Incompleteness

36 Pages Posted: 12 Sep 2008 Last revised: 20 Feb 2010

See all articles by Bert Willems

Bert Willems

Tilburg University - Department of Economics - CentER & TILEC; University of Toulouse 1 - Toulouse School of Economics (TSE)

Joris Morbee

Catholic University of Leuven (KUL) - Center for Economic Studies and Energy Institute

Date Written: September 11, 2008

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.

Keywords: Electricity markets, Financial Markets, Investments

JEL Classification: Q40, G13

Suggested Citation

Willems, Bert and Morbee, Joris, Risk Management in Electricity Markets: Hedging and Market Incompleteness (September 11, 2008). TILEC Discussion Paper No. 2008-031. Available at SSRN: https://ssrn.com/abstract=1266610 or http://dx.doi.org/10.2139/ssrn.1266610

Bert Willems (Contact Author)

Tilburg University - Department of Economics - CentER & TILEC ( email )

P.O. Box 90153 Room K308
Tilburg, 5000LE
Netherlands
+31134662588 (Phone)

HOME PAGE: http://www.bertwillems.com

University of Toulouse 1 - Toulouse School of Economics (TSE) ( email )

Place Anatole-France
Toulouse Cedex, F-31042
France

Joris Morbee

Catholic University of Leuven (KUL) - Center for Economic Studies and Energy Institute ( email )

Belgium

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