An Empirical Analysis of the Impact of Hedge Contracts on Bidding Behavior

Abstract

A major concern in the design of wholesale electricity markets is the potential for the exercise of market power by generating unit owners. To better understand the determinants of generating unit owner market power and how it is exercised, this paper derives a model of bidding behavior in a competitive electricity market which incorporates various sources of uncertainty and the impact of the electricity generator's position in the financial hedge contract market on its expected profit-maximizing bidding behavior. The model is first used to characterize the profit- maximizing market price that a generator would like set by its bidding strategy for several hedge contract and spot sales combinations. This model applied to bid and contract data obtained from the first three months of operation of the National Electricity Market (NEM1) in Australia to answer several questions about the bidding behavior of a major participant in this market. This analysis illustrates the sensitivity of expected profit-maximizing bidding strategies to the amount of financial hedge contracts held by the generating unit owner. It also provides strong evidence for the effectiveness of financial hedge contracts as a means to mitigate market power during initial stages of operation of a wholesale electricity market.