Journal of Energy Markets

The application of structural electricity models for dynamic hedging

Cord Harms and Rüdiger Kiesel

  • Starting from a structural spot model we show how to construct hedging strategies.
  • We show that electricity forwards are cointegrated and implied by the merit order.
  • Reduced-form models and cointegration models do typically not reflect the merit order.
  • The model allows for two hedging strategies depending on power futures liquidity.

We formulate a general structural model for an energy market in order to analyze the dynamic hedging of contingent claims on spot electricity prices. The electricity price is modeled endogenously using a deterministic function depending on a joint fuels and demand process. We state conditions on the fuels/demand dynamics and the bid stack function under which the electricity forwards are martingales. The martingale property allows us to derive hedging strategies. We find that for liquid power forward contracts our model implies cointegrated forwards. As power forward contracts are not always liquid, we construct an alternative hedging strategy where fuels are used to hedge power based on the marginal fuel according to the merit order of the market. As an example, we use the structural model of Carmona, Coulon and Schwarz and test the performance of our hedging strategies in case of a virtual power plant. Based on an hourly hedging profile, we state a result on how to come from an hourly forwards hedging strategy to a hedging strategy using exchange-traded futures (weekly, monthly, quarterly, etc).