Energy price risk management

The price of electricity is far more volatile than that of other commodities normally noted for extreme volatility. Demand and supply are balanced on a knife-edge because electric power cannot be economically stored, end user demand is largely weather dependent, and the reliability of the grid is paramount. The possibility of extreme price movements increases the risk of trading in electricity markets. However, a number of standard financial tools cannot be readily applied to pricing and hedging electricity derivatives. In this paper we present arguments why this is the case.