Exotics and electrons: Electric power crises and the financial risk management

This paper models the real investment and financial portfolio decisions of a regulated utility, selling power at fixed prices to consumers and buying power in an unregulated spot market. Consumer demand is stochastic and subject to large shocks. Utilities can either meet consumers' demand by buying power on the spot market or by adding capacity. The risk associated with a surge in consumer demand can be hedged by trading in a financial derivatives market. Solving for the optimal policy for an individual utility, we show that, as power shortfalls increase, the optimal hedge position is a nonlinear mixture of price risk and quantity risk hedging. We then examine the aggregate impact of these hedging positions and show that the spot price process shifts from a marginal-cost-based regime to a regime based on aggregate financial capacity of the power industry. Although individual utilities, acting as price takers, can lower their expected power shortfalls by hedging with derivatives, derivative demand in the aggregate increases spot price volatility when power default occurs, and may thus increase the number of power defaults. At the same time, punitive regulatory penalties for power defaults may actually increase aggregate defaults by encouraging utilities to hedge outage risks through derivative markets rather than through increased capacity.