Equilibrium Pricing and Optimal Hedging in Electricity Forward Markets

Abstract

Electricity cannot be economically stored, leading to volatile spot prices and implying that standard cost-of-carry relations are not useful for pricing electricity forward contracts. We model spot and forward power markets, evaluating the demand for risk reduction and assessing equilibrium spot and forward power prices. We obtain the implication that the forward price will contain a risk premium that depends on both the variance and the skewness of spot electricity demand. We show that power-producing firms' optimal forward market positions depend on forecast output and on the skewness of power demand. Power retailing firms' optimal forward positions depend on forecast usage, and on two statistical measures of interrelations between local and system demand that we refer to as power betas, and the coskewness of local power demand with system-wide demand. We use available data on electricity futures and spot delivery prices to provide preliminary empirical evidence that is generally consistent with our predictions.

JEL Classification: G0, D4