Hedging and Vertical Integration in Electricity Markets

Abstract

This paper analyzes the interactions between competitive (wholesale) spot, retail, and forward markets and vertical integration in electricity markets. We develop an equilibrium model with producers, retailers, and traders that enables us to quantify the impact of forward markets and vertical integration on prices, risk premia and retail market shares. We point out that forward hedging and vertical integration are two separate mechanisms for demand and spot price risk diversification that both reduce the retail price and increase retail market shares. We show that they are imperfect substitutes as to their impact on prices and firms' utility because of the asymmetry between production and retail segments. Vertical integration restores the symmetry between producers' and retailers' exposure to demand risk while linear forward contracts do not. Vertical integration is superior to forward hedging in presence of highly risk averse retailers. We illustrate our analysis with data from the French electricity market.

Keywords: hedging, forward, wholesale spot price, retail, vertical integration

JEL Classification: g13, g34, l22