Cash-settled options for wholesale electricity markets

TL;DR

This paper proposes a centralized cash-settled call option market for wholesale electricity to help market participants hedge against price volatility, especially with increasing renewable energy sources.

Contribution

It introduces a novel centralized clearing mechanism for cash-settled call options, extending bilateral trading and addressing risk management in electricity markets.

Findings

Centralized options reduce payment volatility for participants.

The mechanism generalizes bilateral trading for better risk mitigation.

Discussion on impact of risk preferences and potential generalizations.

Abstract

Wholesale electricity market designs in practice do not provide the market participants with adequate mechanisms to hedge their financial risks. Demanders and suppliers will likely face even greater risks with the deepening penetration of variable renewable resources like wind and solar. This paper explores the design of a centralized cash-settled call option market to mitigate such risks. A cash-settled call option is a financial instrument that allows its holder the right to claim a monetary reward equal to the positive difference between the real-time price of an underlying commodity and a pre-negotiated strike price for an upfront fee. Through an example, we illustrate that a bilateral call option can reduce the payment volatility of market participants. Then, we design a centralized clearing mechanism for call options that generalizes the bilateral trade. We illustrate through an example how the centralized clearing mechanism generalizes the bilateral trade. Finally, the effect of risk preference of the market participants, as well as some generalizations are discussed.