What is shape risk?

Companies try to plan to ensure they have lower the risk that they don't have enough or have to pay too much for energy to deliver the products or services their clients want through hedging.

Power hedging contracts have granularity though in that they can only be bought in fixed amounts. When those amounts are larger than desired to fit the company's energy requirements the company runs the risk of having to make up the difference at the time of delivery, when the spot price may be much higher.

Where have you heard about shape risk?

Unless you're involved in the buying, selling or production of power it is unlikely you'll have come across the term. Most companies of a decent size hedge in some way though, whether against fuel prices, currency movements or cash flow risks.

What you need to know about shape risk.

Let us work through an example:

Assume you are the operations manager of an iron-smelting company that requires large amounts of electricity to run your smelting ovens. You may wish to pre-purchase your energy to guarantee supply or take advantage of a lower price.

Your energy needs may vary over time. If power can only be bought in, say, units of 1,000kwh then for times when your energy use is predicted to be 9,800kwh you must either over purchase 10,000 kwh or buy 9,000kwh and make up the difference at the spot price, which may be higher.

The risk of paying extra is the shape risk.

Find out more about shape risk.

Shape risk is a form of basis risk that results from imperfect hedging. Other non-hedging types of risk include equity risk, FX risk, interest rate risk and volatility risk.