An analysis of basis risk in the nordic electricity marketand how it can be hedged

Abstract

In the Nordic electricity market, electricity producers face the risk of substantial price variations across time and space. The prices across different geographical areas can differ due to transmission congestion. To hedge against the risk of price variations across time and space the market participants can use forward or future contracts and Contracts for Difference (CfDs), which are listed at Nord Pool. CfDs are forward contracts on the spread between a particular area price and the system price. This paper provides an analysis of the basis risk in the Nordic electricity market, how the electricity producers can hedge the risk of locational and time-varying price differences, and how effective the hedging vehicles being used are. My analysis of the spread between the area prices and system price from 2000 to 2008, and the frequency of transmission congestion underlines the need of risk management for market participants. I also analyse the pricing of CfDs and whether these contracts contains risk premia. I find that most CfDs contain a risk premium; however, the sign and magnitude of the risk premium differ substantially between areas and also between delivery periods. In order to illustrate how an electricity producer can hedge the basis risk he is facing, I constructed a case. The case illustrates that an electricity producer during 2007 and 2008 could significantly reduce his risk by taking certain positions in the financial market.