An Analytical Framework for Valuation and Risk Management in Nordic Hydropower Production

Abstract

With an increasing share of intermittent renewable energy production in the Nordic power market, it is a common belief that the volatility of the electricity price will increase. Therefore, there is a demand for energy resources that can balance the supply. Reservoir hydropower serves as the most appropriate renewable energy resource for balancing purposes. The hydropower companies must be able to manage price risk if their aim is to avoid profit losses in the volatile market. In order to increase the competence in the industry in relation to these challenges, we propose a model for valuation and risk management of reservoir hydropower production.

Existing valuation and risk management models often require significant computational time. With severe and unexpected changes in the market, companies may take on big losses while waiting for output from these models. In contrast, our model involves a tractable analytical framework, which leads to low computational time and still good results.

The thesis contributes to the literature by providing theoretical insight to risk management from an analytical standpoint. Further, the tractable and presentable model contributes to the industry by increasing competence of risk managers. To the best of our knowledge, we are the first to provide an analytically tractable framework for risk management of hydropower production.

We solve the valuation problem as a continuous time stochastic control problem. The operational boundaries are handled by introducing penalty functions in the objective function, and a linear discharge strategy is introduced to retain the analytical framework. In order to provide insights for risk management, we relate price parameter sensitivities of the valuation result to hedging using forward contracts.

We demonstrate the model performance using a case study of a Norwegian hydropower plant. We find that the valuation model yields a reasonable result for valuation of a reservoir hydropower plant. Further, our results show that the hydropower producer may avoid severe profit losses if applying the hedging model before a downward shock to the electricity price.