Exchange-based hedging faces multiple challenges

Our investigation of the Norwegian market for power price hedging shows an apparent reduction in price hedging activity on the exchange and a greater reliance on using physical supply agreements. These changes reflect, among other things, tax changes, poor financial market liquidity and higher collateral costs.


Power price hedging can be achieved through a variety of mechanisms. However, most hedging is achieved either through the use of financial derivates, such as power futures, or through Power Purchasing Agreements that specify a price. On behalf of the Norwegian national energy regulator, we examined power price hedging in Norway, focussing on the different strategies used by market actors and on hedging mechanisms other than the electronic trading of financial power derivates via the exchange.

Hedging strategies vary among individual actors. However, there are marked similarities among the hedging needs and strategies adopted within different groups of market participants. Large consumers typically opt to hedge a significant share (70–90% of next year’s expected consumption) through physical supply agreements. The share of expected consumption hedged is lower for delivery periods further in the future. Retailers offering fixed-price tariffs will typically hedge their entire expected price exposure for the full length of the retail contract. Given the need to adapt the size of hedges rapidly as customers come and go, and the relatively small size of the necessary adjustments, retailers have historically relied on trade in the standardised financial derivatives. Generators typically employ a mixture of instruments and will often have a board-mandated hedging strategy. Norwegian hydropower producers’ hedging strategies are significantly influenced by the Norwegian tax system.

The market for power price hedging has changed in several ways over the last two years. The most important consequences of these changes are:

  • An apparent reduction in the share of hedging activity that is cleared:
    Significant increases in the collateral costs associated with cleared trading, including all trades conducted via the exchange, have led some market participants to move their existing position with the clearing house to uncleared bilateral agreements. The effect of efforts to avoid clearing is clearly visible in market data on the aggregate size of open positions with the clearing house (open interest).
  • A greater share of hedging is being conducted using physical supply agreements:
    Increased collateral costs, a greater need to manage area price risk and poor liquidity in the EPAD market are encouraging actors to meet their hedging needs with the use of physical supply agreements.
  • Lower expected hedging volumes overall:
    Changes to the tax treatment of generators as well as the increased difficulty and costs associated with hedging are expected to reduce the total volumes that are being hedged.
  • Less accurate EPAD prices:
    The combination of illiquid EPAD markets and volatile price drivers is increasing market participants’ scepticism as to the accuracy and usefulness of the EPAD prices available from the exchange.

The lack of liquidity in the EPAD market has several real-world impacts including more costly and limited access to retail fixed-price tariffs, less flexibility from large consumers when considering changes to their production schedules, and less hedging/greater risk-taking among market actors. It also makes EPAD prices less useful as a summary measure of future price expectations, potentially harming the efficiency of decisions relying on such information.

The full report can be accessed following the link below.

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