Exotics and Electrons: Electric Power Crises and Financial Risk Management

This article models the decisions of a regulated utility that has the option of meeting excess demand by buying power on the spot markets. The risk associated with the cost of meeting excess consumer demand can be hedged by trading in a financial derivatives market. We show that the optimal financial hedge position for an individual utility is a nonlinear mixture of price-risk and quantity-risk hedging. The ability to form these hedges in financial markets can increase spot price volatility. The availability of derivatives markets can also lower the value of long-term power contracts and baseload supply.