Location and Basis Risk in Power Markets
Basis risk arises when hedging at a hub or zone that does not perfectly match the physical delivery point.
Locational pricing reflects transmission constraints and losses, so local prices can diverge from hub benchmarks.
Hedging a physical exposure with hub futures leaves residual basis risk from local–hub price differences.
Risk systems must track basis factors and stress scenarios, not just assume a single representative price.
This graphic shows a hub price, a local price with a time-varying basis, and the residual P&L from hedging with hub futures. The bottom band displays daily hedging error, which shrinks near the optimal hedge ratio but never vanishes if basis is volatile.
Local price = hub price + basis. Hedging with hub futures can remove the hub part but leaves you exposed to basis volatility, which appears as residual P&L even for an optimised hedge ratio.
As you move the hedge ratio, the bottom bars shrink and flip. This illustrates that hedge calibration controls how much hub risk remains, but basis risk is separate: it requires explicit modelling, stress testing, and, where possible, local hedges.