Abstract

The deregulation of the electric utility industry has brought with it a great deal of financial uncertainty for market participants. In this report we address the question of how participants can use available markets in order to mitigate this risk. In order to develop effective strategies for trading, one must first have a good understanding of the dynamics of prices on all available markets. We therefore begin by addressing the relationship between financial and physical, spot and forward markets. In doing so we examine the arbitrage pricing theory approach to modeling forward prices, and evaluate its relevance for non-storable commodities. From the basic relationships between the markets, we arrive at stochastic models which quantify future uncertainty in the marketplace.

Next we consider the case of a load serving entity serving load under a standard offer contract. We show how the stochastic models for load and spot prices allows us to quantify the risk exposure of the LSE. Next we formulate the problem of how an LSE can optimally manage its risk using a periodically rebalanced forward portfolio, based on a mean variance objective function. We show that by using the proposed price models, we can convert the problem into a dynamic programming formulation, which can be solved with a number of computationally efficient tools.