The Economics of Electricity Markets

Part VIManaging Risk

Twin hardwood poles carrying 110 kV transmission lines in the Horowhenua area, New Zealand (Source: Neil Rennie)

We have seen that economic efficiency requires that market participants be exposed to the wholesale spot price for electricity. However, that price can be highly volatile. Electricity sellers face the risk of prolonged periods of low prices. On the other hand, electricity buyers face the risk of episodes of very high prices. Both parties may be reluctant to make investments without some way of reducing the risk they face. This is the role played by risk-management instruments. Risk-management tools bridge the gap between the volatile spot prices that provide the correct signal for efficient short-run use and operation of a set of assets, and the long-term price signals needed for efficient investment.