Hedging and tail risk in electricity markets

Abstract

One of the persistent concerns in scarcity-based electricity market designs is that markets for long-term contracts are highly illiquid or ‘missing’. In the context of decarbonisation, a key question arises as to whether this phenomenon will persist or improve as markets transition to greater proportions of zero-marginal cost renewables and storage. Using a stochastic equilibrium model and insights from insurance theory, we consider long-term hedging in the context of credit and financing constraints. For electricity markets dominated by thermal generation, the deliverability of long-term hedges can be significantly impacted by the volatility of thermal fuels and the co-dependence between them under extreme conditions. Our results demonstrate the importance of fuel hedging as an underlying driver of the cost and deliverability of electricity hedging. Where the underlying fuel exposure cannot be contracted, generators may need to price contracts at multiples of the expected value of spot prices. The results provide guidance for discourse on policy and market design in relation to tail risk. One interpretation of the results in this paper is that the lack of contracting for tail risks given a volatile raw commodity is not a market failure per se, but a rational response of market participants due in part to the expense of hedging generation when fuel exposures are unable to be hedged. Counterintuitively, in the context of the energy transition, our results show that, ceteris paribus, increasing the penetration of low carbon resources like wind, solar, and energy storage can add diversity to the risk exposures of the underlying hedge contract.