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Selective Hedging in Hydro-Based Electricity Companies

Olsen, Eirik Tandberg and Sanda, Gaute Egeland and Fleten, Stein-Erik (2010): Selective Hedging in Hydro-Based Electricity Companies.

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We analyze risk management trends in electricity commodity markets using the production and transaction data and written hedging policies of 12 Norwegian hydropower companies. The scope of our analysis is the hedging of physical electricity production using the power derivatives available at NASDAQ OMX Commodities. In their hedging policy, these companies either use a Cashflow at Risk (C-FaR) approach or a hedge ratio approach, or follow no explicitly stated approach. We find that the derivative cashflows constitute substantial profits for these companies. Furthermore, hedging contributes to reducing the C-FaR for 10 of the companies. These findings are surprising considering that we expect hedging to yield zero expected profit and to smooth the earnings function. Overall, our findings reveal that a practice of incorporating market views in hedging decisions is widespread in the sample companies, as both sanctioned in their written hedging policy and as indicated by the substantial hedging profits.

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