Using weather derivatives to improve the efficiency of forward markets for electricity

Abstract

The analysis in this paper demonstrates that a combination of 1) a forward contact, with fixed price for both base land and peaking power, and 2) a collar option for the number of hot days in a summer is an effective way to reduce the risk of purchasing electricity in a spot market. The main advantages are 1) the effectiveness of price signals is strengthened by making peaking power expensive, and 2) the correlation between payouts from the weather option and high prices is increased.