Applications of Modern Portfolio Theory Risk Metrics to the Electrical Grid

Abstract:

Modern portfolio theory (MPT) provides a framework in which investors can construct portfolios that minimizes risk for a given level of expected return. This often involves investors diversifying their portfolios in order to lower the overall price volatility. In the MPT framework, various risk metrics have been defined, including the Herfindahl Hirschman Index (HHI) and the Marginal Contribution to Risk (MCTR). Although these risk metrics are most often applied to financial economics, they may be applied to other fields to assess risks beyond those related to prices. For the electrical power grid, risk can be associated with the generation volatility of a solar power plant, or the chance of a power outage. These risks impact communities and economies, and their importance should not be overlooked. As there is increasing penetration of renewable energy onto the power grid, there is increased variability in energy generation available. The adaptive nature of the energy system in response to these changing patterns of demand predisposes the system to risks since, at certain times, the grid might need to rely more heavily on some sources in order to satisfy demand. In this study, we examine the relationship between various risks within the energy field in the context of the Modern Portfolio Theory framework. These metrics are calculated based on high resolution historical data on generation, demand, and local marginal price in ISO New England from 2014 - 2020. We find that these metrics offer insights into electrical grid reliability and resilience.