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|Title:||Market Completeness - How Options Affect Hedging and Investments in the Electricity Sector|
|Authors:||WILLEMS Bert; MORBEE JORIS|
|Citation:||ENERGY ECONOMICS vol. 32 no. 4 p. 786-795|
|Publisher:||ELSEVIER SCIENCE BV|
|Type:||Articles in periodicals and books|
|Abstract:||The high volatility of electricity markets gives producers and retailers an incentive to hedge their exposure to electricity prices by buying and selling derivatives. This paper studies how welfare and investment incentives are affected when an increasing number of derivatives are introduced. It develops an equilibrium model of the electricity market with risk averse firms and a set of traded financial products, more specifically: a forward contract and an increasing number of options. We first show that aggregate welfare (the sum of individual firms' utility) increases with the number of derivatives offered, although most of the benefits are captured with one to three options. Secondly, power plant investments typically increase because additional derivatives enable better hedging of investments. However, the availability of derivatives sometimes leads to "crowding-out" of physical investments because capital is being used more profitably to speculate on financial markets. Finally, we illustrate that players basing their investment decisions on risk-free probabilities inferred from market prices, may significantly overinvest when markets are not sufficiently complete.|
|JRC Institute:||Institute for Energy and Transport|
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