Working Paper: NBER ID: w23434
Authors: Chen Lin; Thomas Schmid; Michael S. Weisbach
Abstract: Production inflexibility together with product price uncertainty creates price risk, which is a potentially important factor for firms’ liquidity management. One industry for which price risk can be measured is the electricity producing industry. We use data on hourly electricity prices in 41 markets to measure fluctuations in output prices and information on over 60,000 power plants to approximate firms’ flexibilty to vary output quantities. Our results suggest that higher electricity price volatility leads to increased cash holdings, but only in firms using inflexible production technologies. This effect is robust to a number of specification choices including instrumenting for volatility in electricity prices using weather forecast data. After deregulation, firms hold 20-25% more cash, suggesting that the process of deregulation increases the risk firms’ face. Price risk affects cash holdings most in financially constrained firms, and in firms that cannot easily hedge the electricity price through derivative markets. Capital market liquidity and balance sheet liquidity appear to be substitutes for one another.
Keywords: Price Risk; Production Flexibility; Liquidity Management; Electricity Generating Firms
JEL Codes: G3; G32; G35; L5
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| higher electricity price volatility (L97) | increased cash holdings (G32) |
| higher electricity price volatility (L97) | increased cash holdings (especially in firms using inflexible production technologies) (D25) |
| higher electricity price volatility (L97) | increased cash holdings (more pronounced for financially constrained firms) (G32) |
| inflexible production technologies (L23) | increased cash holdings in response to price volatility (G19) |
| price uncertainty (measured using hourly electricity prices) (L97) | cash holdings adjustments (F32) |
| financial constraints (H60) | stronger effect of price volatility on cash holdings (G19) |