Using Binary Prediction Markets as Hedging Instruments: Strategies for Renewable Generators

Abstract

Renewable energy sources face volumetric risk in their revenue streams, in any electricity sale structure, due to changeability associated with weather conditions. Weather/power derivatives are often employed to hedge against such financial risks. This letter proposes that a binary prediction market, if is adequately liquid, has the potential to resemble the function of such derivatives to improve the financial profile of renewable sources. The size and the price of shares (contracts) to be purchased by the renewable generator are determined analytically in the methodology of this paper. To this end, two different approaches have been considered: the indifference utility condition and the maximisation of utility function to reflect different risk preferences of investors.

Hedging Volumetric Risks of Solar Power Producers Using Weather Derivative Smart Contracts on a Blockchain Marketplace

“…Ref. [45] has recently shown that DeFi can minimize such basis risk since the market payoffs are more flexible and liquid than traditional instruments. The same study noted that flexibility comes from the fact that these instruments can be defined directly by the local generation, while liquidity is due to it being accessible to participants from all locations, unlike traditional arrangements that are only available in a few countries.…”

“…The flexibility in structuring DeFi arrangements, as in [29], [45], allows the development and pricing of tailor-made arrangements to meet the specific requirements of SPPs. In practice, the same flexibility can be achieved to hedge basis risks using traditional OTC contracts, as in [3], [53], etc.…”

“…Traditional hedging arrangements are only available in a few countries, and mainly to a few large principal actors (i.e., hedgers and insurers) [15], [35]. However, DeFi fosters a marketplace accessible to participants from all locations, with a range of budget, risk appetite, and trading strategies, as in [45], [49]. Moreover, weather derivative markets are generally illiquid and with the existing participants are forecasted to remain so, as in [22], [34].…”

“…For the same reason, the marketplace could attract other additional actors, including speculators, arbitrageurs, etc. Speculators, such as independent commodity traders or private investors, would bet on the outcomes of the underlying index to make profits [26], [45]. Arbitrageurs, such as independent commodity traders or hedge funds, would also trade smart contract arrangements based on multiple market dynamics to make risk-free profits [34].…”

“…1) Risk metric: Cash flow certainty is critical for renewable electricity generators to attract finance at favorable rates and advantageous terms from traditionally risk-averse financial institutions [3] as well as manage risks during their operational phase [45]. Therefore, the dilemma of an SPP is minimizing its implied cash flow volatility σ δt , as in (23), derived by considering the combined stochasticity of sky clearness and average temperature.…”