Modelling the Hedging Decisions of a Generator with Market Power

The incentive on an electricity generating firm to exercise market power depends strongly on the volume the firm has pre-sold in the forward or hedge markets. Therefore, in order to forecast the effect of mergers and other market developments on market power outcomes, it is essential to model the hedging decisions of dominant generating firms. This paper shows that a dominant firm’s profit-maximizing choice of hedge level depends on the extent to which the hedge price varies with the firm’s hedging decision. In the case in which the hedge price is independent of the firm’s hedge level, the optimal choice of hedging is an “all or nothing” decision. In this case, there is no equilibrium level of hedging in pure strategies. This outcome may explain the observed lack of hedge market liquidity in wholesale electricity markets with substantial market power. We also model the equilibrium hedging outcome in a two-stage Cournot oligopoly and show that, even if the hedge price is independent of the hedging decisions of the firms, a rational expectations equilibrium can exist with high levels of hedging if there are enough firms in the market.