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April 04, 2011
Brattle Economists Demonstrate that Three-Asset Hedging Strategies Significantly Mitigate Financial Risk

Economists at The Brattle Group released a discussion paper today that demonstrates that three-asset hedging strategies that address power, fuel, and carbon price uncertainty can significantly mitigate the financial risks associated with owning and operating power plants. The authors used numerical simulations to show that using three-asset hedging strategies, as opposed to two-asset hedging strategies that only address power and fuel, can result in a two-thirds reduction in overall cash flow variation over a three-year horizon. Consequently, while being overall profit neutral in expectation, cash flows can be raised by over 50 percent 10 percent of the time. The results of their hedging exercise are directly relevant to any power plant operator who questions the potential benefits of carrying out a three-asset hedging strategy. Whether falling under the European Union’s carbon dioxide Emission Trading Scheme or in other jurisdictions where regulators are planning to address emissions costs through market means, power generators will increasingly need to consider emissions as another commodity associated with plant operations and become accustomed to treating emissions on equal footing with the more traditional commodities of power and fuel. The paper, “Cleaning Up Spark Spreads: How Plant Owners Can Reduce Risk Through Carbon Markets,” was authored by Brattle principals Michael Cragg and Richard Goldberg, associate Varoujan Khatchatrian, and former research analyst Jehan DeFonseka.