Abstract of Meeting Paper

Society for Risk Analysis-Europe 1997 Annual Meeting

Risk Management on a Deregulated Electricity Market. Inzemar Rickenlund. IR, JAPRO Gruppcn AB, Stockholm, e-mail ir@aprogruppen.se

1. Background

The Nordic electricity market has, as a pioneer market, bow deregulated and is now a competitive market, probably the most developed electricity market in the world. Electricity has some unique characteristics; it is not storable and production and consumption must equal every second throughout the year. The Nordic electricity market is probably the most volatile market in the world, because of the unsuitability of the supply and the demand curve. The supply curve is very unstable since hydro production capacity vanes due to how much it rams and how well water could be stored in water reservoirs. The demand curve is also very unstable since many households use electricity for direct heating and the consumption vanes due to changes in the weather. For example, the spot price on electricity averaged 25 6re/kWh in 1996, while the average spot price in 1995 only was 11 6re/kWh. Moreover, there are substantial price differences over the year (normally higher prices in the winter than in the summertime) as well as over the day (normally how prices during peak load (daytime). Today there exist both a spot and a future market for electricity contracts and there is also a fairly liquid OTC-market for bilateral contracts.

2. Risk Analysis

The players now compete and one very important task is risk analysis and risk management. For an electricity trader the risk logic is very similar to any other market, as long as he only buys and sells standardised fixed volume contracts. For the trader we could use normal price and position risk techniques for risk analysis and hedging. For a physical player (generator, supplier and Large end users) however, the position of the portfolio is uncertain depending on how much production capacity he will have during the period. In a similar way the supplier who sells to end customers with take-and-pay contract, the sales/consumption will very much due to weather (temperature). Especially if the player is vertically integrated (both generation and supply) the risk logic becomes very complex. in addition, some of the contracts on this market are very complex and they need to be decomposed very carefully in order to fully understand which the risks are. What also makes the risk logic interesting is that different risk drivers effect the value of the portfolio differently depending on the time horizon of the analysis period.

3. Risk Management

Risk management has become a critical issue for the players. Much of the problems faced are however a change management issue. In the Old World (pre-deregulation) there was no real risk in the industry since the customer always had to pay in the end. For the managers, risk management is therefore a new and uncertain issue. Specific issues that must be addressed by utility managers are; 1) How should risk policies and limits be set, controlled and reported, 2) How should the organisation be adjusted to manage both the physical reality (production planning, meetings etc.) as well as the financial (contracts), 3) Which trading, risk and portfolio management systems need to developed as well as decision support and management information system. Furthermore risk management is a core function for the utility on a deregulated market and the managers need to asses the risk issues when evaluating different strategies to be pursued for the utility. Could the risk management experience from other financial market be applied on this market or is there a need for adjustment?

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