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Abstract Hydrologic variability poses an important source of financial risk for hydropower‐reliant electric utilities, particularly in snow‐dominated regions. Drought‐related reductions in hydropower production can lead to decreased electricity sales or increased procurement costs to meet firm contractual obligations. This research contributes a methodology for characterizing the trade‐offs between cash flows and debt burden for alternative financial risk management portfolios, and applies it to a hydropower producer in the Sierra Nevada mountains (San Francisco Public Utilities Commission). A newly designed financial contract, based on a snow water equivalent depth (SWE) index, provides payouts to hydropower producers in dry years in return for the producers making payments in wet years. This contract, called a capped contract for differences (CFD), is found to significantly reduce cash flow volatility and is considered within a broader risk management portfolio that also includes reserve funds and debt issuance. Our results show that solutions relying primarily on a reserve fund can manage risk at low cost but may require a utility to take on significant debt during severe droughts. More risk‐averse utilities with less access to debt should combine a reserve fund with the proposed CFD instrument in order to better manage the financial losses associated with extreme droughts. Our results show that the optimal risk management strategies and resulting outcomes are strongly influenced by the utility's fixed cost burden and by CFD pricing, while interest rates are found to be less important. These results are broadly transferable to hydropower systems in snow‐dominated regions facing significant revenue volatility.