Hedging and Vertical Integration in Electricity Markets

This paper analyzes the interactions between competitive (wholesale) spot, retail, and forward markets and vertical integration in electricity markets. We develop an equilibrium model with producers, retailers, and traders to study and quantify the impact of forward markets and vertical integration on prices, risk premia and retail market shares. We point out that forward hedging and vertical integration are two separate mechanisms for demand and spot price risk diversification that both reduce the retail price and increase retail market shares. We show that they differ in their impact on prices and firms’ utility due to the asymmetry between production and retail segments. Vertical integration restores the symmetry between producers’ and retailers’ exposure to demand risk while linear forward contracts do not. Vertical integration is superior to forward hedging when retailers are highly risk averse. We illustrate our analysis with data from the French electricity market. ∗We would like to thank Enrico Biffis, Denis Gromb, Michel Habib, Xuewen Liu, Frédéric Loss, Antonio Mello, Linda Rud, Jean Tirole, Robert Wilson, Wei Xiong (the Editor), the Associate Editor, two anonymous referees, and seminar participants at European Finance Association 2009 meetings, the University of British Columbia, Simon Fraser University, Imperial College Business School, Cass Business School, the University of York, the University of Durham, the University of Zurich, the University of Lugano, l’Université Libre de Bruxelles, the University of Toulouse, the University Bordeaux Montesquieu and the University of Paris-Dauphine for helpful comments. The paper has also benefited from numerous discussions with Jérôme Wirth and Cyrille Strugarek at EDF R&D. The authors thank the Finance for Energy Markets research center for financial support. †EDF R&D and Finance for Energy Market research centre, EDF R&D, 1, avenue du Général de Gaulle, F-92141 Clamart Cedex FRANCE. Tel: 33 (0)1 47 65 46 86, email: [email protected] ‡Imperial College Business School, DRM-CNRS, and CEPR. Imperial College Business School, South Kensington campus, London SW7 2AZ, United Kingdom. E-mail: [email protected] §Deutsche Bank and Finance for Energy Market research centre. Finance for Energy Market research centre, University Paris-Dauphine, Place du Marechal de Lattre de Tassigny, 75775 Paris cedex 16, www.fime-lab.org, France. Email: [email protected]. ¶Ecole polytechnique. Centre de Mathématiques Appliquées, 91128 Palaiseau cedex, France. E-mail: [email protected], tel: +331 6933 4612. Research supported by the Chair Finance and Sustainable Development sponsored by EDF, Credit Agricole CIB and CDC.