Risk management in power markets: The Hedging value of production flexibility

Since the 1990s power markets are being restructured worldwide and nowadays electrical power is traded as a commodity. The liberalization and with it the uncertainty in gas, fuel and electrical power prices requires an effective management of production facilities and financial contracts. Thereby derivatives build essential instruments to exchange volume as well as price risks. The challenge for participants in the newly competitive market environment is how to design, price and hedge derivative contracts in particular combination with the flexibility embedded in dispatch strategies of production assets. Accordingly, an adequate basis for management and investment decisions is needed which responds to the highly complex market situation. This research project is gratefully supported by the Swiss Innovation Promotion Agency KTI/CTI in collaboration with the industrial partner Nordostschweizerische Kraftwerke AG. McKinsey and Company, Inc., Taunustor 2, 60311 Frankfurt, Germany Institute for Operations Research, ETH Zentrum, CH-8092 Zurich, Switzerland National University of Singapore, Department of Mathematics, 2 Science Drive, 117543 Singapore Corresponding Author, [email protected]