Electricity Price Modeling and Analysis

The financial literature is full of several publications which are aimed to describe the behavior of stock and bond prices, as well as a number of different other securities. However, the financial academic community has produced much less work dealing with energy commodities models. Electricity price modeling in particular represents a field which has a great potential of significant improvements, since electricity prices are subject to specific features and behaviors which make them substantially different from stocks or more traditional commodities.

The aim of this section is to analyze the peculiarities of electricity prices [...]. In particular, it plots te daily prices (expressed in US dollars per megawatt/hour) of PJM electricity prices, in a time range from May 2007 to April 2012. PJM is one of the major electric exchanges in the US, covering an area between Pennsylvania, New Jersey and Maryland.

The features that can be noticed from the plot (and that are typical of electricity prices) are mean reversion, time varying volatility, a seasonal behavior and the presence of huge and sudden upward jumps in prices (the so called “spikes”). We will describe all of these features individually, and we will take all of them into account to build a proper model for electricity spot prices. Some of these features are also evident in other commodity prices (for example, natural gas and oil), but the magnitude by which they appear in electricity prices is unique.

So, before starting any analysis, it is worth wondering why electricity prices behave in a way that is not common to other security or commodity prices. A partial answer is that electricity owns a very peculiar characteristic: non-storability. In fact, electricity cannot be stored in warehouses like the great majority of commodities, and at any moment demand has to be met by electricity produced at the same time. So, electricity prices are primarily driven by spot demand and supply. As Geman and Roncoroni (2006) point out, electricity demand in the short term market is fairly inelastic and cannot be met clearing the inventory, and shocks in production (for example a power plant outage, a disruption of transmission utilities or extreme weather conditions that may undermine production) or increased consumption (a heat wave in summer) may give rise to high price jumps.