[BETA] Fortnightly

The Risk that Wasn't Hedged: So What's Your Gamma Position?

 

Power markets often show coincident peaks in price and volume.
That can make profit unusually volatile.

Force equals mass times acceleration (F=ma). Any student of physics should know this equation. In other words, force doesn't just increase with added mass; rather, it accelerates in its strength.

The same can be said for profits in the energy business. For in power markets, the moment of maximum liability to supply the highest volume of electricity to meet retail demand often corresponds precisely with the highest of superpeaks in the wholesale price of energy. This conspiracy of events-so crucial to understanding the energy business-can produce a surprisingly rapid rise or fall in profits. And this risk, known in finance as "gamma" risk," may well have escaped much notice among utilities and load-serving entities.

To understand how and why, remember that in most states, deregulation largely means a disaggregation of generation from retail load. That event carries profound risk management consequences that can be analyzed using the financial market concept of gamma risk.

In this article, I will show that generation represents a long gamma position, while retail load generally represents a short gamma position. Furthermore, without liquid markets to price and transfer this risk, it will be the owners of generation who become the early beneficiaries of deregulation. Thus, any "energy companies" operating in competitive retail markets will require the necessary tools for hedging this risk. (No distinction is drawn here between utilities and unregulated generators or load-serving entities. I use the term "energy company" to describe an enterprise with a retail or wholesale position in energy.)

Understanding Gamma: Two Examples

Many finance textbooks describe gamma risk in detail. Here, in the two examples that follow, assume that our energy company operates in a floating price environment. And for our purposes, imagine gamma risk as the second differential of profitability with respect to price. "Delta," in turn, represents the sensitivity of profitability with respect to price, but it does not stay constant as prices change.

Generation. Consider a power plant with a marginal cost of $100 per megawatt-hour (MWh). As forward prices move from $30 to $50, there is little change to the potential profitability of this plant. However, as forward prices move from $90 to $110, we see a large change to the profitability of the plant. Figure 1 illustrates this situation, and shows the incremental profitability of a portfolio of generation with diversified marginal costs.

In this example, delta is not constant; or in other words, gamma is a value other than zero. Also, delta is rising as prices rise, so gamma is positive. Gamma is positive because as prices rise, profitability rises at a faster and faster rate as additional plants become economic. Graphically, profitability as a function of price is convex, as shown in Figure 2.

Retail Load. Now consider an energy company that serves retail load through "full requirements" or "standard-offer" service. Retail load requirements generally are correlated with other load for weather and behavioral reasons, and hence, with