ssrn-id638322 - Understanding the Fine Structure of...

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Understanding the Fine Structure of Electricity Prices H&LYETTE GEMAN University Paris Dauphine ± ESSEC Business School ANDREA RONCORONI * ESSEC Business School ± Bocconi University Forthcoming in the Journal of Business, vol. 79, no. 6, 2006. * Corresponding Author , Finance Department, ESSEC Business School, Avenue B.Hirsch BP 105, 95021 Cergy-Pontoise, France. Tel.: +33(0)134433239; Fax.: +33(0)134433001; E-mail: roncoroni@essec.fr Key Words : Electricity Prices, Jump Di/usions, Statistical Estimation, Calibration, Sim- ulation, Energy Price Risk. JEL Classi&cation : c51, c52, g12, q40, c13, c15.
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Abstract This paper analyzes the special features of electricity spot prices derived from the physics of this commodity and from the economics of supply and demand in a market pool. Besides mean-reversion, a property they share with other commodities, power prices exhibit the unique feature of spikes in trajectories. We introduce a class of discontinuous processes exhibiting a &jump-reversion& component to properly represent these sharp upward moves shortly followed by drops of similar magnitude. Our approach allows to capture - for the ±rst time to our knowledge - both the trajectorial and the statistical properties of electricity pool prices. The quality of the ±tting is illustrated on a database of major US power markets. 2
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I. Introduction A decade ago, the electricity sector worldwide was a vertically integrated industry where prices were set by regulators and re&ected the costs of generation, trans- mission and distribution. In this setting, power prices used to change rarely, and in an essentially deterministic manner. Over the last ten years, major countries have been experiencing deregulation in generation and supply activities. One of the important consequences of this restructuring is that prices are now deter- mined according to the fundamental economic rule of supply and demand : there is a ±market pool±where bids placed by generators to sell electricity for the next day are confronted to purchase orders. In a parallel way, deregulation of the energy industry has paved the way for a considerable amount of trading activity, both in the spot and derivative markets. Price risk has in particular forced the industry to identify, price and hedge the options granted in energy contracts that have been written for decades. Given the unique non-storability (outside hydro) of this commodity, electricity prices are much more likely to be driven by spot demand and supply consider- ations than for any other good, with demand in the short-term market being fairly inelastic. As a result, sizeable shocks in production or consumption may give rise to the price jumps which have been observed since 1998 in various parts in the United States. Leaving aside the California 2000 events which were pos- sibly driven by &aws in market design and wrongdoings on the part of some 3
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major players, spike prices have been motivated by disruption in transmission, generation outages, extreme weather or a conjunction of these circumstances.
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ssrn-id638322 - Understanding the Fine Structure of...

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