Modelling electricity prices by the potential jump-diffusion

Abstract

In liberalized electricity markets prices exhibit features, such as price spikes, rarely seen in other commodity markets. Models for electricity spot price, such as mean-reverting jump-diffusions and regime-switching models are only partially successful in modelling price spikes. In this paper we introduce a new approach to electricity price modelling: a potential function jump-diffusion model, which allows for a continuously varying mean-reversion rate and provides a flexible way to model price spikes. We analyze electricity spot prices from three major European power exchanges: Amsterdam Power Exchange, UK Power Exchange and European Power Exchange (Germany). The potential function jump-diffusion model is applied to the historical spot prices from these exchanges, and its performance is compared to that of the mean-reverting jump-diffusion. The potential function approach is able to capture price spike behavior and overall characteristics of the data remarkably well, and generally better than traditional mean-reverting models. This approach allows for a continuum of different reversion rates, and hence provides a richer model structure and significantly extends the regime-switching model of Huisman and Mahieu [13].

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