Electricity derivatives and risk management

Electricity spot prices in the emerging power markets are volatile, a consequence of the unique physical attributes of electricity production and distribution. Uncontrolled exposure to market price risks can lead to devastating consequences for market participants in the restructured electricity industry. Lessons learned from the financial markets suggest that financial derivatives, when well understood and properly utilized, are beneficial to the sharing and controlling of undesired risks through properly structured hedging strategies. We review different types of electricity financial instruments and the general methodology for utilizing and pricing such instruments. In particular, we highlight the roles of these electricity derivatives in mitigating market risks and structuring hedging strategies for generators, load serving entities, and power marketers in various risk management applications. Finally, we conclude by pointing out the existing challenges in current electricity markets for increasing the breadth, liquidity and use of electricity derivatives for achieving economic efficiency. (C) 2005 Elsevier Ltd. All rights reserved.