Models for Electricity Prices

The deregulation of electricity markets has led to higher uncertainty in electricity prices. Electricity, as a commodity, differs from other commodities and financial assets as it is not storable. Among the consequences of this non-storability restriction, the most conspicuous one is the presence of large spikes in electricity prices. Another outcome of the non-storability of electricity is that the classic no-arbitrage relationship between spot prices and forward prices no longer makes sense in electricity markets. This essay focusses on two models for electricity prices: Barlow (2002) and Aid et al. (2009). Both models capture the distinct features exhibited by electricity prices. We review, in detail, each model and then explore the connection between them. We find that the model proposed by Barlow (2002) can be interpreted as a continuous version of the model by Aid et al. (2009). We use Barlow’s model to price forwards and derivatives on electricity and briefly illustrate how to simulate prices using numerical procedures.