April2024OIESPaper:EL53HedgingandTailRiskinElectricityMarketsFarhadBillimoria,VisitingResearchFellow,OIES,andDirector,S&PGlobalPowerMarketsJacobMays,AssistantProfessor,CornellUniversityRahmatallahPoudineh,HeadofElectricityResearch,OIESiiThecontentsofthispaperaretheauthors’soleresponsibility.TheydonotnecessarilyrepresenttheviewsoftheOxfordInstituteforEnergyStudiesoranyofitsMembers.Thecontentsofthispaperaretheauthors’soleresponsibility.TheydonotnecessarilyrepresenttheviewsoftheOxfordInstituteforEnergyStudiesoranyofitsmembers.Copyright©2024OxfordInstituteforEnergyStudies(RegisteredCharity,No.286084)Thispublicationmaybereproducedinpartforeducationalornon-profitpurposeswithoutspecialpermissionfromthecopyrightholder,providedacknowledgementofthesourceismade.NouseofthispublicationmaybemadeforresaleorforanyothercommercialpurposewhatsoeverwithoutpriorpermissioninwritingfromtheOxfordInstituteforEnergyStudies.ISBN978-1-78467-240-9iiiThecontentsofthispaperaretheauthors’soleresponsibility.TheydonotnecessarilyrepresenttheviewsoftheOxfordInstituteforEnergyStudiesoranyofitsMembers.AcknowledgementsWewishtoacknowledgewithoutimplicatingMalcolmKeay,Dr.DavidRobinson,andProf.PaulSimshauserforinsightfulcommentsandfeedbackonearlierversionsofthispaper,andDr.DarrylBiggarforhelpfuldiscussionsonthecontextandcontentofthework.AbstractAconcernpersistentinscarcity-basedmarketdesignsforelectricityovermanyyearshasbeentheilliquidityofmarketsforlong-termcontractstohedgeawayvolatilepriceexposuresbetweengeneratorsandconsumers.Thesemissingmarketshavebeenattributedtoarangeoffactorsincludingretailercreditworthiness,marketstructureandthelackofdemandsideinterestfromconsumers.Usingastochasticequilibriummodelandinsightsfrominsurancetheory,wedemonstratetheinherentchallengesofhedgingalegacythermalportfoliothatisdominatedbyvolatilefat-tailedcommoditieswithsignificanttaildependence.Undersuchconditionsthepricerequiredforgeneratorstoprovidesuchhedgescanbemultiplesoftheexpectedvalueofprices.Ourkeyinsightisthatwhenthereal-worldconstraintsofcreditandfinancingareconsidered,thevolatilityofthermalfuelsandtheirco-dependenceunderextremesmaybeakeyreasonastowhyelectricitymarketshavebeenincompleteintermsoflong-termhedgingcontracts.Counterintuitively,inthecontextoftheenergytransition,ourresultsshowthat,ceterisparibus,increasingthepenetrationoflowcarbonresourceslikewind,solarandenergystorage,canaddtail-diversityandimprovecontractability.ivThecontentsofthispaperaretheauthors’soleresponsibility.TheydonotnecessarilyrepresenttheviewsoftheOxfordInstituteforEnergyStudiesoranyofitsMembers.ContentsAcknowledgements.............................................................................................................................iiiAbstract................................................................................................................................................iiiContents...............................................................................................................................................ivFigures..................................................................................................................................................ivTables...............................................................................................................................................