Setting Up Standard Power Options to Hedge Price-Quantity Risk in a Competitive Electricity Market: The Colombian Case

Abstract

This paper applies the conceptual framework applied in the work of Oum <etal xmlns:mml="http://www.w3.org/1998/Math/MathML" xmlns:xlink="http://www.w3.org/1999/xlink"/> to hedge retailers against price-quantity fluctuations in spot electricity markets, and extends it to power generators, in order to design suitable power options with optimal strike prices from a market maker's perspective. These options are then used to hedge agents against price and quantity fluctuations by maximizing a static expected utility problem. An infinite collection of derivatives (“exotic option”) emerges as the solution of both price and quantity hedging. This exotic option is approximated with a portfolio composed by bonds, forward/futures contracts, and a fixed number of put and call options, employing a plausible replicating strategy. The theoretical framework is tested within the context of the Colombian power market, and is applied to month-ahead and quarterly-ahead hedging during on-peak hours. The proposal addresses major problems such as lack of liquidity and anonymity of the current bilateral electricity trading scheme in Colombia.