What hedging is – and what it isn’t

By Chris Bowden

April 29, 2026 • READING TIME 3 MIN

In our discussions with energy buyers, we hear some confusion about what it means to hedge power prices, and what power price hedging should set out to do. This blog aims to address some of the misconceptions that we hear and explain why hedging is an essential activity for most businesses.

Hedging in this context is the act of reducing or eliminating exposure to an economic risk by entering into a contract that creates an offsetting position. The idea is that the value of the hedge contract moves in the opposite direction to the underlying economic exposure – ensuring that it is effectively neutralised.

Putting a hedge in place can prevent an unwelcome spike in the price of a commodity, such as power, hitting a company’s profitability. Hedging is less about taking a view on future prices and more about locking in costs at a level that will help ensure a business can operate profitably in future.

How companies hedge

As with most hedging products, there is enormous scope for complexity and sophistication in approaches to hedging, and the use of options, swaps and structured products to finely tailor hedge strategies and manage the associated costs. Some work like insurance policies, offering protection against extreme outcomes in exchange for a premium. Others can be cost-free, where counterparties with opposite exposures swap cashflows.

But, in most cases, companies use simple hedges to lock in the price at which they will buy inputs or sell outputs at a point in the future.

In the context of electricity consumption, the fundamental exposure is straightforward: companies that consume power need to buy it in the future, but they don’t know what it will cost. They have a long price risk – and rising wholesale prices will directly increase their operating costs.

To hedge this exposure, the company can enter into a forward contract with a trading firm or their supplier, under which it agrees to buy a certain volume of power at an agreed price in the future. Typically, the hedger would enter into a forward contract each month, quarter or season, fixing its expected baseload consumption several months or even years into the future.

The alternative – floating to spot

The alternative to hedging is to float power to spot, whereby the company’s supplier passes through whatever the day-ahead or within-day market delivers at the time of consumption. The buyer is not creating an offsetting position but is simply accepting the market price as it arrives. If wholesale prices spike – as they did dramatically in 2021–2022 – the buyer bears the full impact in its bills.

This approach is essentially running an open position and is not hedging – energy costs are fully exposed to wholesale market movements with no protection in place. In plain terms, it’s unhedged procurement. The buyer’s budget is only as stable as the market which, as recent years have shown, can be anything but.

Some buyers float prices because they conflate hedging with spot market exposure and make the mistake of analysing spot prices versus forward prices. When they do this analysis, they find that over a long period of time spot prices deliver lower than forward prices do. This isn’t a startling conclusion as forward prices contain premiums.

You can think of forward electricity prices as:

Forward = Average expected spot + Scarcity value + Risk premium

Most of the time, average spot prices follow a predictable pattern, increasingly pulled down by renewables when the system is well supplied and much higher when gas sets the price. If you simply averaged those outcomes, you would arrive at a number which is lower than the forward curve predicted. That’s often where people start — and where they go wrong.

Forward prices are not built on that average. They are shaped by what happens when the system is under stress. In those periods, prices don’t just edge up; they spike, sometimes dramatically. These events might be infrequent, but they skew the risk to the upside. A small number of extreme days can do more damage than long periods of low prices can repair. That is what sits behind the scarcity value.

On top of this sits the risk premium. Buyers are not trying to predict the market; they are trying to remove uncertainty from their cost base. Sellers, in turn, need to be compensated for taking that uncertainty on. The result is a price that includes a buffer for things not going to plan.

Taken together, this means forward prices reflect the cost of avoiding extreme outcomes, not the expectation of an average one. In a market like UK power — where price spikes are sharp and the downside doesn’t meaningfully offset them — that cost is material.

So when forwards appear higher than realised spot prices over time, it doesn’t mean the market has mispriced the future. It means the market has priced the risk.

There are cases where buyers don’t hedge their power purchases. This can be a legitimate strategy if the company has the risk tolerance to accept it and the treasury function to manage it actively. But this should not be confused with hedging; floating to spot – even on part of a consumer’s volume - is not a hedging strategy, it's the absence of one.

When not to hedge

There are circumstances where it makes sense not to hedge an input cost such as electricity. If higher costs can be passed through to customers, perhaps through indexing in contract terms, then essentially there is no exposure to be hedged.

Second, if common practice among the company’s peers and competitors is to remain unhedged, the company may find itself at a competitive disadvantage, or may be punished by shareholders, if it is unable to benefit when prices fall because it has contracted through its hedge to buy at higher prices. (Conversely, of course, if power prices rise and its competitors are unhedged, it could take advantage to keep its prices low and gain market share.)

Seizing certainty

Recent events in Ukraine and Iran show that there are clear advantages in putting a hedging programme in place to create certainty around input costs. In most industries, shareholders pay a premium for companies that generate consistent cashflows over their more volatile competitors.

While the fundamental principles of hedging are straightforward, a more sophisticated approach can turn a hedge position into a means to take advantage of near-term price movements. How power consumers approach the active management of the hedge position will be the subject of the next blog.