Electricity portfolio management: Optimal peak/off-peak allocations
Introduction
In many countries electricity markets are liberalized. As a result large electricity purchasers, e.g. large industrial consumers and electricity retail distribution companies, need to contract the future expected electricity consumption (load) for their own company or for a pool of clients. In liberalized electricity markets, they can do so by managing a hedging portfolio of contracts that involve delivery of electricity in future time periods and/or financially settle the difference between a fixed and a variable price. Examples of such contracts are day-ahead contracts, derivatives such as forwards, futures, swaps, variable volume or swing options and direct or indirect investments in energy production facilities.1 Proper management of the load hedging portfolio involves a continuous assessment of (a) the types of instruments (contracts) to buy or sell and (b) at what moment the portfolio needs to be rebalanced according to the risks the electricity purchaser prefers to take. An obvious objective of the purchaser is to incur the lowest expected costs for the expected electricity load, given a specific risk target.
Since the beginning of the liberalization of energy markets, researchers have primarily focused on the price characteristics of different energy commodities and the valuation of derivative contracts. Traditionally the academic literature has dealt with proposing optimal hedging strategies using commodity futures.2 The issue of constructing efficient portfolios for electricity purchasers has received much less attention in the academic literature. Given the sometimes extreme price fluctuations in energy commodities, we feel that this issue is grossly undervalued. Poorly constructed portfolios exhibit either too high expected costs at a given risk level or, alternatively, too much risk for the current level of expected costs. This paper focuses on optimal instrument selection for a rational electricity purchaser that cares about the mean and variance of the future sourcing costs. It specifically tackles the question how electricity purchasers should choose between peak and off-peak forward contracts in order to structure their portfolios optimally. To do so, we construct a simple one-period framework and cast the allocation problem in a portfolio framework to find the optimal allocations to the forward contracts and the day-ahead market.
The paper is organized as follows. Section 2 discusses the literature on energy portfolio management. In Section 3 we present our model. Section 4 highlights some managerial implications of the model and provides answers to the questions how a company should purchase a baseload consumption profile and whether taking risk is rewarded by lower expected costs. Section 5 concludes.
Section snippets
Portfolio structuring in electricity markets
In order to facilitate trading of power contracts many countries have established over-the-counter (OTC) and centralized markets. The two most prevalent markets are the day-ahead and forward/futures markets. On the day-ahead market, traders can submit bids and offers for amounts of electricity to be delivered in the individual hours of the next day. This market is the closest equivalent to a spot market.3
The purchase decision in a one-period framework
At time t, consider an electricity purchaser who has to decide on how to purchase the consumption for future delivery of electricity at day T. We have that t < T − 1, i.e. the hedging decision needs to be made at least 2 days before the delivery period.8 Delivery takes place in all hours of day T. The actual consumption volume during hour h on day T
Managerial implications
In this section, we apply the outcomes of the model from the previous section to address two fundamental questions that purchasers deal with in practice.
Concluding remarks
In this paper we have introduced a one-period framework to examine the optimal allocations to peak and off-peak forward contracts of a rational electricity purchaser who wants to hedge both price and volumetric risks. The results show that building an optimal portfolio with electricity forward contracts is a two-step procedure. First, purchasers find the optimal allocation to peak contracts relative to off-peak contracts in order to profit from differences in the relative hedging cost
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