A multi-factor polynomial framework for long-term electricity forwards with delivery period

TL;DR

This paper introduces a multi-factor polynomial model for long-term electricity forwards that enables explicit computation, easy calibration, and risk-minimizing hedging using liquid contracts, addressing market illiquidity issues.

Contribution

The paper presents a novel polynomial framework for modeling and hedging long-term electricity forwards with explicit calculations and practical calibration methods.

Findings

Model can be calibrated to 8 years of German forward curves

Hedge strategy effectively minimizes risk over various horizons

Framework improves tractability and hedging accuracy in illiquid markets

Abstract

We propose a multi-factor polynomial framework to model and hedge long-term electricity contracts with delivery period. This framework has several advantages: the computation of forwards, risk premium and correlation between different forwards are fully explicit, and the model can be calibrated to observed electricity forward curves easily and well. Electricity markets suffer from non-storability and poor medium- to long-term liquidity. Therefore, we suggest a rolling hedge which only uses liquid forward contracts and is risk-minimizing in the sense of F\"ollmer and Schweizer. We calibrate the model to over eight years of German power calendar year forward curves and investigate the quality of the risk-minimizing hedge over various time horizons.