A composite index-based instrument for managing the financial risk of variable hydrometeorology for electric utilities

Extreme hydrometeorological conditions impact electric utilities’ financial stability, with drought often reducing electricity supply (e.g., hydropower), while heat waves increase electricity demand. A model of U.S. West Coast power systems is combined with a financial model of an electric utility, Pacific Gas and Electric (PG&E), to characterize hydrometeorological financial risk and develop novel tools for managing it. A novel index contract based on hydrology, temperature, and electricity prices is developed. The composite index contract achieves equivalent reduction in PG&E’s net revenue variance as a portfolio of traditional contracts for roughly half the cost. The same conditions that increase utilities’ financial risk also give rise to increases in air pollution as more-polluting electricity sources must be dispatched to meet demand. An alternative regulatory scenario involving pollution taxes is explored. The composite index contract is shown to significantly reduce risks in this setting, thereby reducing disincentives for this public health intervention.