An integrated theory of dispatch and hedging in wholesale electric power markets

The literature on optimal dispatch of wholesale power systems implicitly assumes that market participants are risk-neutral. But, in practice, most wholesale electricity market participants behave as though they are risk averse, seeking to insulate themselves from the market risks they face. In this context, achieving the overall social-welfare maximum requires simultaneously finding both the optimal dispatch and optimal hedging arrangements. Assuming that market participants have mean–variance preferences, we show that the dispatch task can be separated from the hedging task. We show how market participants can achieve a perfect hedge by forming a portfolio of inter-temporal hedge contracts. Departing from the previous literature, we assume the system operator is risk averse. We show how the system operator can achieve a perfect hedge using a portfolio of inter-nodal hedging instruments which we refer to as generalised Financial Transmission Rights. The total risk experienced by market participants when optimally hedged is equal to the variation in the total surplus or total economic welfare. This approach therefore leads naturally to a form of merchant transmission investment where network upgrade decisions are carried out by a coalition of risk-bearers in the market. In addition, we propose a natural extension in which transmission network operators provide a form of insurance against network outages, and face the correct social incentive for avoiding network outages. This approach resolves a number of outstanding issues in the economic analysis of power markets.