Cross hedging and forward-contract pricing of electricity

We consider the problem of an electric-power marketer offering a fixed-pric e forward contract to provide electricity that it purchases from a potentia lly volatile and unpredictable fledgling spot energy market. One option for the risk-averse marketer who wants to hedge against the spot-price volatil ity is to engage in cross hedging to reduce the contract's profit variance, and to determine the forward-contract price as a risk-adjusted price - the sum of a baseline price and a risk premium. We show how the marketer can e stimate the spot-price relationship between two wholesale energy markets fo r the purpose of cross hedging, as well as the optimal hedge and the forwar d contract's baseline price and risk premium. (C) 2001 Elsevier Science B.V . All rights reserved.