The efficacy of financial futures as a hedging tool in electricity markets

• Date: 01 January 2018
• Published date: 01 January 2018
• DOI: http://doi.org/10.1002/ijfe.1600
• Author: Damien Cassells,Lucia Morales,Jim Hanly

RESEARCH ARTICLE

The efficacy of financial futures as a hedging tool in

electricity markets

Jim Hanly

1

| Lucia Morales

2

| Damien Cassells

1

1

Accounting and Finance, Faculty of

Business, Dublin Institute of Technology,

Dublin, Ireland

2

School of Accounting and Finance,

Dublin Institute of Technology, Dublin,

Ireland

Correspondence

Jim Hanly, Accounting and Finance,

Faculty of Business, Dublin Institute of

Technology, Aungier Street, Dublin,

Ireland.

Email: james.hanly@dit.ie

JEL Classification: G10; G12; G15

Abstract

This paper estimates and applies a risk management strategy for electricity spot

exposures using futures hedging. We apply our approach to 3 of the most

actively traded European electricity markets, Nordpool, APXUK, and Phelix.

We compare both optimal hedging strategies and the hedging effectiveness of

these markets for 2 hedging horizons, weekly and monthly using both Variance

and Value at Risk. Our key finding is that electricity futures can effectively

manage risk only for specific time periods when using hedging strategies that

have been very successful in financial and other commodity markets. More gen-

erally, they are ineffective as a risk management tool when compared with

other energy assets. This is especially true at the weekly frequency. We also find

significant differences in both the optimal hedge ratios and the hedging effec-

tiveness of the different electricity markets. Better performance is found for

the Nordpool market, whereas the poorest performer in hedging terms is the

Phelix market.

KEYWORDS

electricity futures, GARCH, hedging, riskmanagement

1|INTRODUCTION

Following the deregulation and liberalisation of electricity

markets in Europe, several power markets exchanges now

facilitate the trading of electricity. This process has resulted

in power companies shouldering the risk of adverse price

movements as regulators no longer automatically allow

them to transfer risk to their customers through price

increases. In turn, this has generated a demand for deriva-

tive products to allow for hedging those price risks. Hedg-

ing with futures contracts has become a standard way of

managing commodity price risk, particularly with refer-

ence to energy markets, and standardised futures contracts

are now traded on many power exchanges.

A large literature has documented the use and effec-

tiveness of futures as a hedging tool since early work by

Ederington (1979). This literature has examined equities

(Cotter & Hanly, 2012; Kanas, 2009), various commodities

(Chen & Sutcliffe, 2012; Wu, Guan, & Myers, 2011),

foreign exchange (Kroner & Sultan, 1993; Röthig, 2011),

portfolio products such as exchange traded funds (Alexan-

der & Barbossa, 2008), and energy commodities such as

crude oil and natural gas, (see e.g., Brinkmann &

Rabinovitch, 1995; Chang, McAleer, & Tansuchat, 2011;

Fraser & McKaig, 2000). The general results from the lit-

erature are that hedging is generally very effective as mea-

sured by risk reductions of the order of 60–90% depending

on the underlying asset being hedged. Some assets have

shown better hedging effectiveness, notably stock indices

and certain oil contracts such as West Texas Intermediate

that have shown hedging effectiveness above 95% in some

instances.

There has been relatively little work that has exam-

ined electricity price hedging using futures within the

Received: 8 December 2017 Accepted: 13 December 2017

DOI: 10.1002/ijfe.1600

Int J Fin Econ. 2018;23:29–40. Copyright © 2018 John Wiley & Sons, Ltd.wileyonlinelibrary.com/journal/ijfe 29