Competitive electricity markets

The electricity spot prices in the (still emergent and conturbated) restructured/deregularized power markets are volatile, a consequence of the unique physical attributes of current (i.e., prehistoric) electricity production and distribution architectures, such as (general) non-storability, uncertain and inelastic demand, and a steep supply function. The majority of the recent (and highly polemical) electricity crises and their considerable economic (and political) consequences were largely attributed by the convenient critics to the fact that major utilities were not properly hedged through long term supply contracts (meaning that sector participants were "uncontrollably" exposed to, … OMG!, to market price risks).

Some lessons learned from the previous state (i.e., unregulated) of financial markets suggest that financial derivatives, when well understood and properly utilized, are sufficiently beneficial to sharing and controlling undesired risks through properly structured (although sometimes complex) hedging strategies.

Hedging maximizes the firm's value by reducing the likelihood of financial distress and its ensuing costs, or by reducing the variance of taxable incomes and its associated present value of future tax liabilities. However, regulatory rules most often play a disproportionately important role in hedging practices.

If the volatile but (wannabe) competitive electricity markets would be allowed to maturate, generation companies, power marketers and Load Serving Entities (LSEs) would naturally seek some viable level of certainty in their costs and revenues through voluntary hedging practices, contracting and active trading. Such activities involve quantifying, monitoring and controlling trading risks in the wholesale and retail markets, which in turn require appropriate risk management tools and methodologies.

On the supply side, managing risks associated with (desirably decentralized) long term investment in generation and transmission requires methods and tools for planning under uncertainty and for asset valuation. Unfortunately, much of the current demands for generation asset valuation methods rise from regulatory efforts to centrally mandate specific levels of investment in generation capacity in order to meet their highly subjective and artificial measures and objectives of supply adequacy and system reliability.

Worldwide generation industry reforms have originally constructed an idealized theoretical paradigm under which shareholders bear all the investment risk and consumers bear the price risk, with free competitive entry pushing capacity toward the "desired" long term equilibrium. In such an ideal market environment, suppliers and consumers are free to choose their desired level of risk exposure, achieved through voluntary risk management practices. Unfortunately, this vision was not allowed to be fully developed, primary due to political resistance to high prices reflecting scarcity rents and shortages and to overcome serious market imperfections such as the lack of demand response.

Most restructured electricity markets around the world have backed away from the economic market models and instituted price caps, various capacity payment mechanisms, and even reintroduced some kind and level of centralized investment planning. Such regulatory interventions typically aim to allocate risks between consumers and producers by rather contradictorily limiting the degree to which market participants are exposed to the natural motion of a decentralized economy. From a risk management perspective, these intervention schemes are usually mandatory backstop hedging. In theory, the proper design of such schemes requires the same pricing and asset valuation tools as voluntary risk management practices in a competitive market. However, in practice, some governments have even instituted heavy, costly, centralized institutional settings wholly dedicated to evaluate assets and mandate pre-specified forms of risk management practices, all in the sacred name of the fuzzy (and actually impossible to specify) concept of collective welfare.

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