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The natural hedge of a gas-fired power plant

Guo, X; Beskos, A; Siddiqui, A; (2014) The natural hedge of a gas-fired power plant. Computational Management Science , 13 (1) pp. 63-86. 10.1007/s10287-014-0222-x. Green open access

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Abstract

Electricity industries worldwide have been restructured in order to introduce competition. As a result, decision makers are exposed to volatile electricity prices, which are positively correlated with those of natural gas in markets with price-setting gas-fired power plants. Consequently, gas-fired plants are said to enjoy a “natural hedge.” We explore the properties of such a built-in hedge for a gas-fired power plant via a stochastic programming approach, which enables characterisation of uncertainty in both electricity and gas prices in deriving optimal hedging and generation decisions. The producer engages in financial hedging by signing forward contracts at the beginning of the month while anticipating uncertainty in spot prices. Using UK energy price data from 2006 to 2011 and daily aggregated dispatch decisions of a typical gas-fired power plant, we find that such a producer does, in fact, enjoy a natural hedge, i.e., it is better off facing uncertain spot prices rather than locking in its generation cost. However, the natural hedge is not a perfect hedge, i.e., even modest risk aversion makes it optimal to use gas forwards partially. Furthermore, greater operational flexibility enhances this natural hedge as generation decisions provide a countervailing response to uncertainty. Conversely, higher energy-conversion efficiency reduces the natural hedge by decreasing the importance of natural gas price volatility and, thus, its correlation with the electricity price.

Type: Article
Title: The natural hedge of a gas-fired power plant
Open access status: An open access version is available from UCL Discovery
DOI: 10.1007/s10287-014-0222-x
Publisher version: http://dx.doi.org/10.1007/s10287-014-0222-x
Language: English
Additional information: © The Author(s) 2014 This article is distributed under the terms of the Creative Commons Attribution License which permits any use, distribution, and reproduction in any medium, provided the original author(s) and the source are credited.
UCL classification: UCL
UCL > Provost and Vice Provost Offices
UCL > Provost and Vice Provost Offices > UCL BEAMS
UCL > Provost and Vice Provost Offices > UCL BEAMS > Faculty of Engineering Science
UCL > Provost and Vice Provost Offices > UCL BEAMS > Faculty of Engineering Science > UCL School of Management
UCL > Provost and Vice Provost Offices > UCL BEAMS > Faculty of Maths and Physical Sciences
UCL > Provost and Vice Provost Offices > UCL BEAMS > Faculty of Maths and Physical Sciences > Dept of Statistical Science
URI: https://discovery.ucl.ac.uk/id/eprint/1452528
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