Energy Supply Risk Premium: Review and Methodological Framework

Abstract

In this article we explain why traditional risk management techniques in the energy sector are not suitable for constructing and quantifying an Energy Security Index which will incorporate all risk parameters that endanger the uninterrupted flow of energy supplies among the numerous energy routes from their destination to European countries. Following an extensive desktop research we present financial techniques and concepts that provide appropriate methods for constructing such an index. Finally, utilizing some of the concepts already discussed, we present the methodological framework in order to develop an Energy Security Index.

Keywords:

• catastrophe derivatives
• energy security
• jump diffusion
• Poisson process
• risk premium

Notes

¹Only for the case of electricity.

²Mean reversion is a tendency for a stochastic process to remain near or tend to return over time to a long-run average value. For example interest rates and implied volatilities that tend to exhibit mean reversion see http://www.riskglossary.com/link/mean_reversion.htm.

³Both of the terms catastrophe and catastrophic are used to refer to the same financial instruments.