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Risk management in the electricity market
Risks must be managed
In economic risk analysis, an economic value can be assigned to every possible outcome. In most cases, the economic value of an outcome is the net financial benefit associated with that particular outcome. In this context, risk might be defined as not getting an outcome within one particular range of values or greater than a threshold value. In finance, risk is the possibility of negative payoffs from derivatives, portfolios, and activities.
The term “risk management” is used to describe any kind of action that controls or changes the risk. This may be an increase or decrease in risk. Risk management can generally be defined as changing the risk to meet the decision maker’s attitude toward risk. The objective of risk management is to ensure that contract positions, trades, insolvency, and operations do not expose the company to losses leading to financial default.
Risk management in the electricity market is a relatively new area that has been introduced after the restructuring of the electricity industry. Market players face new uncertainties such as price uncertainty. The price of electricity depends on supply and demand, and the price formation is complicated by the fact that electricity is non-storable and that supply must equal demand in real-time. Management of different types of risk as well as management of the total electricity portfolio puts great requirements on expertise. Effective risk management will give the market player information about uncertainty in future net benefits. The market players would therefore achieve a more conscious attitude towards their exposure limits. Rational human behavior is identified to be risk-averse. A risk-averse agent seeks to reduce the uncertainties in net benefits. It will therefore be important to identify, assess, monitor, and control risks associated with activities within an electricity business company.
The management of an electricity business company must assess its risk exposures and establish rules for the contract portfolio that is consistent with the risk profile of the company. Furthermore, all risks should be understood, measured, and controlled. Appropriate risk measures and tools are therefore important. For an electricity company, all of the revenue and cost items would vary with the outcome of different factors. The important variable is the associated risk exposure of the sum of the items. Generally, an increased expected profitability brings higher risk, including the possibility of severe losses.
In finance, portfolio management has the objective to invest in a combination of assets that gives the highest expected return subject to the investor’s risk profile. In the electricity market this means buying and selling the contracts that give the company the lowest purchasing price or highest selling price based on a chosen risk preference. One of the strategies to reduce the risk in finance is to diversify, but this option is limited in electricity markets (assuming a single agent). The company must evaluate its total portfolio of contracts and activities and calculate how a single contract contributes to the total risk. When entering into a single electricity contract, the relevant risk is the risk associated with the total portfolio.
Risk hedging can be done by modifying physical (hydropower) generation plans, or by using financial contracts. An electricity company should hedge when the benefit probability distribution is changed such that the benefit is greater than the hedging costs, or when it is cheaper for the company than the owner to accomplish hedging. Hedging results in less volatile profit but requires skilled competence to analyze the electricity market. Forward prices may be used for the valuation of assets and marking-to-market of electricity portfolios.