## The unorthodox model of risk pricing behind the UK EMR #4: no value to hedging

The UK’s Electricity Market Reform (EMR) White Paper suggests that providing low-C generation projects with a hedge of the wholesale electricity price can lower the cost of providing low-C electricity. Can this be?

No.

A fairly priced hedge changes both the project’s risk and it’s return. The first order effect of the two is to leave the risk-adjusted cost of the project unchanged. This is commonly known as the M-M Proposition of Hedging.

In an earlier post I showed a stylized graph of a low-C generator’s revenue, costs and profit margin, all unhedged, and associated with them a present value for each of the three cash flow streams using a simple risk-pricing model. Now, using the exact same risk-pricing model I can construct a fair value hedge. A fair value hedge is one with NPV=0. The hedge is a swap in which the low-C generator sells the floating cash flow, tied to the wholesale electricity price, and receives the fixed cash flow: The level of the floating cash flow is chosen to perfectly hedge the revenue stream. The level of the fixed cash flow is chosen to make the value of the swap zero. The risk-pricing model used to assess the two swap cash flows is exactly the same as the model used to assess the risk in the generator’s revenue and cost cash flows.

Although the value of the two cash flows are the same, the expected net cash flow is negative. The fixed cash flow is less than the expected floating cash flow. This is because the counterparty to the swap is accepting a costly risk, and in order for the hedge to be NPV=0, the low-C generator must pay the counterparty a premium on average in order to compensate them for taking the risk. The value of the cash flow premium exactly counterbalances the cost of the risk being hedged.

Here is the low-C generator’s hedged cash flow position: The revenue stream is exactly as before. The cost stream incorporates the hedge, and now fluctuates together with the revenue stream. Therefore the profit margin is now fixed. This figure should be compared against the unhedged low-C generator’s cash flows which we showed in our earlier post, but for convenience we reproduce again here. Note that the value of the hedged cost stream is exactly the same as the value of the unhedged cost stream. The value of the hedged profit margin is exactly the same as the value of the unhedged profit margin. This must be true, according to the M-M Proposition of Hedging.

Note that while the value of the cost stream is unchanged by the hedging, both its risk and it’s average level are shifted. The cost is now riskier, and, on average, higher.  These results are mirrored in the profit margin. While the value of the profit margin is unchanged by the hedging, both its risk and it’s average level are shifted. The profit margin is now less risky, and, on average, lower. This reflects the fact that the low-C generator pays for the hedge. It doesn’t come for free. And, first order, the cost paid in the level of the cash flow matches the cost avoided in the riskiness of the cash flow.

Hedging is valuable, but it is also costly. The net value is zero.

…Unless society is providing a subsidy through the guise of a hedge.

More on that later.