Electricity Spot and Derivatives Pricing under Market Coupling

Abstract

Increasing interconnectivity between electricity wholesale markets requires an efficient allocation scheme in order to provide access to scarce cross-border transmission capacities. The explicit schemes have primarily induced economically inefficient interconnector use given that flows have to be nominated prior to spot market clearing. By contrast, the market coupling mechanisms avoid these inefficiencies by implicitly allocating cross-border transmission capacity upon spot market clearance. In this paper, we show that these institutional aspects of market design clearly manifest in the empirical dynamics of both electricity spot and derivatives prices, and hence, do have important implications for pricing and hedging in these markets. Since traditional reduced-form models fail to reproduce such effects of market microstructure, we employ a fundamental multi-market model for electricity pricing in order to analyze how the key stylized facts of electricity spot, futures, and options prices are impacted by the different allocation schemes.

Keywords: Electricity Pricing, Fundamental Model, Multi-Market Modeling, Derivatives

JEL Classification: G12, G13, Q4, Q41