Should I hedge this spread with a spread option or an insurance product?

Question

My firm generates electricity from wind. Accordingly, most of my generation takes place at night, when prices are low -- and, due to congestion / oversupply, often sharply negative -- so much so that the spread between daytime and nighttime (or, more generally, "peak" and "off-peak") prices itself is often negative.

While my first instinct was to hedge this spread with derivatives (either an spread option using Kirk's approximation or using a bear vertical spread), I noticed that the spread between the daytime and nighttime period is random across days and across months in futures as well as real-time markets, so I'm wondering if such an approach is workable. Alternatively, I am considering an extreme-value theory approach, whereby I would create an insurance product based on the probabilities and expected shortfalls of negative spreads -- akin to a CDS.

Could someone please weigh in on this situation? I don't want to abandon a market-based approach -- but, in what appears to be an either highly inefficient or highly unstable market, it seems the derivatives approach is unusable.

Answer 1

In my experience this is not easily hedgeable.

Expected volume can be hedged using baseload futures, or, if you are in a very liquid market (Germany) a combination of baseload and peak. You will still be exposed to the intraday shape, and, in the long term (you can hedge the first months and quarters but at some point you need to resort to calendar products) to the intrayear shape. The best way of dealing with that risk is adding the right assets to your portfolio if your company can do such a thing (the right combination of wind and solar becomes almost baseload).

Then there is also the volume/price correlation risk: prices are generally going to be lower when your wind farm produces more wind. The only way I know of hedging that is by weather derivatives, and, in general, the margin on those is too high so most generators carry the risk.

There is also the imbalance risk, related to the forecast error in your plant. Again, the only way I know of hedging that is by using physical assets, as CCGTs, batteries or hydro power that allows to profit from the imbalance market while you make losses with your wind farm.

Answer 2

I know this is perhaps the type of answer you seek, but there are alternative hedging products such as PPAs which could help with this. PPAs can be structured in many ways to allow for parties involved to be happy with the outcome.

An as-produced PPA would probably solve your above issue. However, the outcome from a discussion regarding pricing would probably lead to prices which have been discounted from the baseload prices, so your realized revenue per unit power sold will be much lower than if sold perfectly at baseload prices.

Question yourself this: could you create a synthetic as-produced PPA (without another predetermined known party taking the profile risk)? Like Juan mentioned above, there is not really a known way to do this without complementing generation with other kinds of energy sources or storage solutions - at least not for long-term hedging.