Center on Financial Risk in Environmental Systems (CoFiRES)

Center on Environmental Financial Risk: Roanoke Basin

Roanoke Basin (North Carolina/Virginia)

Mitigating hydrologic financial risk in hydropower generation

Variability in streamflows can lead to intermittent and unpredictable reductions in hydropower generation and the corresponding reductions in revenues can be financially disruptive. Innovative financial instruments can be developed to mitigate this risk at a very reasonable cost.

Roanoke Basin project graphic
This link between hydrologic and financial uncertainties, and the possibility of increased hydrologic variability in the future, suggests that hydropower producers need to begin to consider new strategies and tools for managing these financial risks. This study uses an integrated hydro-economic model of the Roanoke River Basin to characterize the financial risk faced by hydropower generators as a result of hydrologic variability, and develops index-based financial contracts intended to mitigate this risk. Different indices are evaluated in terms of their ability to serve as the basis for effective contracts and alternative contract structures (e.g., collar) are developed and evaluated using a 100-year simulation that describes hydropower operations in the Roanoke basin. We show that consideration of year-to-year changes in the value of hydropower (i.e., the cost of replacing it with an alternative energy source during droughts) is critical to reducing contract basis risk. In particular, we find that volatility in the price of natural gas, a key driver of peak electricity prices, can significantly degrade the performance of index insurance unless contracts are designed to explicitly consider natural gas prices when determining payouts. Results show that a combined index whose value is derived from both seasonal streamflows and the spot price of natural gas yields contracts that exhibit both lower basis risk and greater effectiveness in terms of reducing financial exposure.

Foster, B. F., Kern, J. D. and G. W. Characklis (2015). “Mitigating Hydrologic Financial Risk in Hydropower Generation Using Index-based Financial Instruments,” Water Resources
and Economics, 10, pp. 45-67, doi:10.1016/j.wre.2015.04.001

Kern, J. D., Characklis, G. W. and B. F. Foster (2015). “Natural Gas Price Uncertainty and the Cost Effectiveness of Hedging Against Low Hydropower Revenues Caused by Drought,” Water Resources Research, 51, doi:10.1002/2014WR016533.

Hydro Research Foundation (U.S. Dept of Energy funded program)
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National Science Foundation: Graduate Research Fellowship Program
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UNC Institute for the Environment
UNC Institute for the Environment