Risk is substantial in power markets, and hedging is essential. Our first paper in this issue, “A new approach to evaluating the cost-efficiency of complex hedging strategies: an application to electricity price–volume quanto contracts” by Sang Baum Kang, Michael K. Ong and Jialin Zhao, looks at the complexity and cost-effectiveness of quanto derivatives. These derivatives have been attracting increasing attention, and The Journal of Energy Markets has published several of the most important papers on this theme. The use of electricity quanto contracts, however, suffers from the high risk premiums associated with customized and illiquid financial instruments. As a result, it is highly relevant to evaluate the cost-efficiency of these complex hedging deals. To address this, the authors propose a new hedging assessment based on the economic value of the incremental expected shortfall (EVIES). Using Monte Carlo simulation, they avoid the issues of analytical methods by not relying on risk neutrality, market completeness or unobservable inputs. In their numerical examples, they assume a power supplier has access to electricity price derivatives, weather derivatives and electricity quanto contracts, and they show that their approach can be applied to (1) construct a cost-effective hedge against an electricity price–volume joint risk, (2) find a partial equilibrium for the valuation of electricity quanto contracts, and (3) locate hedging solutions for achieving a specific risk management target. This approach should become widely applied.
In our next paper, “The risk markup of intermittent renewable supply in German electricity forward markets” by Marius Paschen, we see an empirical analysis of how power shocks resulting from intermittent renewables affect forward prices and risk premiums in the German electricity market. This analysis identifies a positive monthly wind shock creating a specific risk markup on forward prices. The wind shock effect on monthly peak-load premiums is larger than on base-load premiums. In the short term, no daily wind and solar shock effects are found. As a consequence, the author considers the need to introduce wind power futures to reduce the risk markup for participants in forward markets.
Turning to the subject of gas, the issue’s third and final paper, “Managing supply chain risk through take-or-pay gas contracts in the presence of buyers’ storage facilities” by Koray D. Simsek, Çaǧrı Haksöz and Metin Çakanyildirim, opens by observing that the downstream segment of the natural gas industry has increased its capital expenditure on storage facilities. This is presumably to increase supply flexibility and minimize operational risks. In this paper, the authors therefore study the enhanced value of a take-or-pay gas contract from a buyer’s perspective in the presence of spot market trading and local storage capability. They use a multistage stochastic program with a computationally efficient split-variable formulation. Their solution identifies the impact of various key managerial levers on the design, valuation and usage of the take-or-pay contract. Among these, the net convenience yield, storage cost and take- or-pay contract terms are identified as being the most important. This paper provides substantial managerial insights.
All three of our papers are motivated by energy market risks and provide quite different, but practically relevant, analyses. These themes have been, and will continue to be, central to the publishing objectives of The Journal of Energy Markets.
Derek W. Bunn
London Business School
A new approach to evaluating the cost-efficiency of complex hedging strategies: an application to electricity price–volume quanto contracts
In this paper, the authors propose a new hedging assessment model, the economic value of the incremental expected shortfall (EVIES), from a cost-efficiency perspective.
This paper presents an empirical analysis of how power shocks resulting from intermittent renewables affect the forecast error of the forward premium in German electricity markets.
Managing supply chain risk through take-or-pay gas contracts in the presence of buyers’ storage facilities
In this paper, the authors study the enhanced value of a take-or-pay gas contract from a buyer’s perspective in the presence of spot market trading and local storage capability.