Solar Energy Risks: Stochastic Radiation Modeling and Optimal Hedging Strategies

The growing integration of solar power into electricity markets increasingly demands advanced risk management tools to address the inherent variability of solar radiation and its interaction with electricity prices. This paper introduces a novel framework for modeling and pricing new financial instruments designed to link payoffs directly to solar radiation levels, namely SoRad and SoREd. The proposed methodology models solar radiation through a bounded transformation and a Markov-modulated Ornstein-Uhlenbeck diffusion, where the latent regime is a two-state continuous-time Markov chain (CTMC) with month-dependent generator. The model captures persistent switches between high- and low-radiation regimes while preserving tractable conditional moments for pricing. Building on the observed correlation between solar radiation and electricity prices, we derive mean-variance equilibrium prices and hedging rules that combine solar derivatives with electricity futures at the pricing date. The resulting prices are interpreted as inception-date valuations for contracts over a fixed delivery period, not as a full dynamic secondary-market equilibrium. The proposed instruments provide standardized tools for transferring solar radiation risk and reducing residual exposure to weather-driven and electricity-linked revenue fluctuations.