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Reducing the Impacts of Energy Price Volatility Through Dynamic Portfolio Selection

This paper uses financial portfolio theory to demonstrate how the energy mix consumed in the United States could be chosen given a national goal to reduce the risky to the domestic macroeconomy of unanticipated energy price shocks. An efficient portfolio frontier of U.S. energy consumption is constructed using time-varying variances and covariances estimated with generalized autoregressive conditional heteroskedastic models. The set of efficient portfolios developed are intended to minimize the impact of price shocks, but are not the least cost energy consumption bundles. The results indicate that while the electric utility industry is operating close to the minimum variance position, a shift towards coal consumption would reduce price volatility for overall U.S. energy consumption. With the inclusion of potential externality costs, the shift remains away from oil but towards natural gas instead of coal.

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Energy Specializations: Petroleum – Markets and Prices for Crude Oil and Products; Energy Investment and Finance – Public and Private Risks, Risk Management; Energy Modeling – Energy Data, Modeling, and Policy Analysis; Electricity – Markets and Prices

JEL Codes:
L13 - Oligopoly and Other Imperfect Markets
D81 - Criteria for Decision-Making under Risk and Uncertainty
E61 - Policy Objectives; Policy Designs and Consistency; Policy Coordination
D42 - Market Structure, Pricing, and Design: Monopoly

Keywords: Electricity price volatility, GARCH, price shocks, electric utilities, policy

DOI: 10.5547/ISSN0195-6574-EJ-Vol19-No3-6

Published in Volume19, Number 3 of The Quarterly Journal of the IAEE's Energy Economics Education Foundation.