Market Completeness: How Options Affect Hedging and Investments in the Electricity Sector

Posted: 13 Feb 2011 Last revised: 17 Feb 2011

See all articles by Bert Willems

Bert Willems

UCLouvain - LIDAM / CORE; 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: July 1, 2010

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

Keywords: Electricity Markets, Financial Markets, Market Completeness, Hedging, Investments, Options

Suggested Citation

Willems, Bert and Morbee, Joris, Market Completeness: How Options Affect Hedging and Investments in the Electricity Sector (July 1, 2010). Energy Economics, Vol. 32, No. 4, 2010, Available at SSRN: https://ssrn.com/abstract=1760629

Bert Willems (Contact Author)

UCLouvain - LIDAM / CORE ( email )

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

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Joris Morbee

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

Belgium

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