A stochastic fuel switching model for electricity prices

This paper develops and applies a novel electricity price model. We reproduce the merit order of a thermal-dominated electricity system by establishing a non-linear dependency of wholesale electricity prices on the prices of fuels (coal and natural gas) and of CO2 emission allowances. The coefficients are estimated using a Markov Switching Regression. This approach might prove valuable for cross-hedging positions in the fuel, electricity and emission spot markets. It is also of use for studying the degree to which electricity prices in different countries reflect fuel and emission cost. Applying the model to the electricity markets of the UK and Germany, we find that British electricity prices are quite well-explained by short-run cost factors while the German ones are less well-explained. (C) 2012 Elsevier B.V. All rights reserved.