Toward hedge ratios for hydropower production

Abstract

The electricity price and production volume determine the revenue of a hydropower producer. Inflow variations to hydro reservoirs and high price volatility result in significant cash flow uncertainty. A copula-based Monte Carlo model is used to relate price and production volume, and to find optimal hedge ratios through minimization of risk measures such as variance, hedge effectiveness, cash flow at risk and conditional cash flow at risk. All risk measures argue for an optimal hedge ratio between 35 and 60\% of expected production. The highest risk reduction is achieved by the use of forward contracts with long time to maturity, but at the expense of a low risk premium. Conversely, short-term futures and forwards only provide marginal risk reduction, but can yield attractive positive risk premiums. These findings underline the importance of distinguishing the use of derivative contracts for speculation and hedging purposes, through positions in short-term and long-term contracts respectively.