Reduced Form Electricity Spot Price Modeling

Since the early 1990s, an increasing number of countries worldwide have liberalized their electricity power sectors. Contrary to before, when power sectors were not open to competition and prices were set by regulators according to the cost of generation, transmission and distribution, electricity prices are now determined by an equilibrium of supply and demand. On one hand, electricity contracts are traded over the counter through bilateral agreements. On the other hand, the deregulation of electricity markets has led to the creation of organized electricity exchanges, where electricity is quoted almost as any other commodity. One effect of the liberalization of electricity markets is the introduction of substantial price risk with volatilities much higher than on stock markets and distinct features like impressive price spikes. Therefore, a precise statistical modeling of electricity price behavior is necessary for energy risk management, pricing of electricity-related options, and evaluation of production assets. In this article, we give a short introduction to modern electricity markets, before we focus on an overview of reduced form models for electricity spot prices proposed in the literature. 1. A short introduction to electricity markets Since the early 1990s, an increasing number of countries worldwide have liberalized their electricity power sectors. Contrary to before, when power sectors were not open to competition and prices were set by regulators according to the cost of generation, transmission and distribution, electricity prices are now determined by an equilibrium of supply and demand, which introduces a substantial price risk with volatilities much higher than those of equity prices. A big share of the total electricity in liberalized power markets is traded over the counter through bilateral agreements. There exists a rich variety of exotic options traded in this market. On the other hand, similar to Date: June 29, 2009.