Risk Management in Electricity Markets Emphasizing Transmission Congestion

This thesis analyzes transmission pricing, transmission congestion risks and their associated hedging instruments as well as mechanisms for stimulating investments in transmission expansion. An example of risk management in the case of a hydropower producer is included. After liberalization and restructuring of electricity markets, risk management has become important. In particular the thesis analyzes risks due to transmission congestion both in the short- and long-term (investments) for market players such as generators, loads, traders, independent system operators and merchant investors. The work is focused on the northeastern United States electricity markets and the Nordic electricity markets. The first part of the thesis reviews the literature related to the eight research papers in the thesis. This describes the risks that are relevant for an electricity market player and how these can be managed. Next, the basic ingredients of a competitive electricity market are described including the design of the system operator. The transmission pricing method is decisive for hedging against transmission congestion risks and there is an overview of transmission pricing models considering their similarities and differences. Depending on the transmission pricing method used, locational or area (zonal) pricing, the electricity market players can use financial transmission rights or Contracts for Differences, respectively. In the long-term it is important to create mechanisms for investments in transmission expansion and the thesis describes one possible approach and its potential problems. The second part comprises eight research papers. It presents empirical analyses of existing markets for transmission congestion derivatives, theoretical analyses of transmission congestion derivatives, modeling of merchant long-term financial transmission rights, theoretical analysis of the risks of the independent system operator in providing financial transmission rights, an analysis of inefficiencies associated with ignoring losses when utilizing area (zonal) pricing, and an application of an integrated risk management model on the power system of Norway’s second largest hydropower producer. The most important research findings include the following issues. First, Contracts for Differences in the Nordic market appear to be over-priced. Second, a merchant long-term financial transmission rights model is possible to realize in mathematical and economic terms. Third, by including the proceeds from a financial transmission right auction the independent system operator can issue a higher volume of rights because there is a relationship between the congestion rent, the proceeds from the auction and the payments to the financial transmission rights holders. Fourth, ignoring losses in the Norwegian area pricing, can lead to inefficiencies. Next, an integrated risk management model is applicable on large-scale power systems. Then, an overview is presented of different contractual arrangements that can be used to hedge transmission congestion risks. Finally, empirical data from existing financial transmission rights markets demonstrate how these markets work