Modeling electricity spot prices: combining mean reversion, spikes, and stochastic volatility

Abstract

With the liberalization of electricity trading, the electricity market has grown rapidly over the last decade. However, while spot and future markets are currently rather liquid, option trading is still limited. One of the potential reasons for this is that the electricity spot price process remains a puzzle to researchers and practitioners. In this paper, we propose an approach to model electricity spot prices that combines mean reversion, spikes, negative prices, and stochastic volatility. Thereby, we use different mean reversion rates for ‘normal’ and ‘extreme’ (spike) periods. Furthermore, all model parameters can easily be estimated using historical data. Consequently, we argue that this model does not only extend the academic literature on electricity spot price modeling, but is also suitable for practical purposes, such as an underlying price model for option pricing. © 2012 Taylor & Francis.