1. ¹Energy and Environmental Economics, Inc., 353 Sacramento Street, Suite 1700 San Francisco, CA 94111, USA
2. ²University of Florida, Gainesville, FL 32611-7169, USA

Correspondence: C-K Woo, Energy and Environmental Economics, Inc., 353 Sacramento Street, Suite 1700, San Francisco, CA 94111, USA. E-mail: ck@ethree.com

Received January 2003; Accepted September 2003; Published online 9 June 2004.

Abstract

A local electricity distribution company (LDC) can reduce its exposure to the inherent risks of spot-price volatility and uncertain future demand via forward contracts. Management's problem is to determine the optimal forward-contract purchase. We propose a practical three-stage approach for dealing with the problem. The first stage determines an optimal purchase by solving a cost-constrained risk-minimization problem. The second stage derives the efficient frontier of tradeoffs between expected cost and cost risk from the first-stage solution, at various bounds on the expected cost. The optimal solution is found by melding the frontier with management's risk preferences. In the third stage, the model's parameters are estimated from data typically available to an LDC and used to determine its forward-contract purchase.