U.U.D.M.

Project Report 2014:18

Mean-Reverting Stochastic Models for the

Electricity Spot Market

Viktor Edward

Examensarbete i matematik, 15 hp
Handledare och examinator: Johan Tysk
Maj 2014

Department of Mathematics
Uppsala University
Contents

1 Introduction 3

2 Electricity markets 3

2.1 The spot market . . . . . . . . . . . . . . . . . . . . . . . . . 4

3 Spot price model and parameter estimation 7

3.1 The seasonal part . . . . . . . . . . . . . . . . . . . . . . . . . 8

3.2 The Ornstein-Uhlenbeck process . . . . . . . . . . . . . . . . . 9

3.3 The Spike Process . . . . . . . . . . . . . . . . . . . . . . . . . 15

4 The calibrated model 17

4.1 Monte Carlo predictions . . . . . . . . . . . . . . . . . . . . . 18

4.2 Forward pricing . . . . . . . . . . . . . . . . . . . . . . . . . . 19

5 Discussion and conclusions 21

1
Abstract

The liberalization of the electricity market has led to higher volatility and
occasional price spikes. To protect both buyers and sellers, contracts are
needed which requires good understanding of the underlying unit, the daily
spot price.

A stochastic model of the spot price is suggested which is the exponen-

tial of the sum of a deterministic seasonal function, an Ornstein-Uhlenbeck
stochastic process and a spike process. This model is suggested after observ-
ing strong seasonality with some mean-reverting stochastic behaviour and
occasional spikes in historical data.

Calibrating the model is non-trivial since one function and two stochastic
processes are estimated out of one data-set and a method for this is sug-
gested. First the seasonal function is estimated, the Ornstein-Uhlenbeck
process is then estimated from the deseasonalized data and then the spikes
are estimated from extreme outliners.

Using the calibrated model the future spot price is predicated using a Monte
Carlo method and some forward contracts are priced.

2
1 Introduction

In the early 1990s some countries started to liberalize their electricity mar-
kets. From being operated by the government where the price was set to
reflect the marginal cost of production, the market changed to be run by
the free market principle of supply and demand. The market became much
more volatile compared to before which created a demand for contracts to
protect from high prices but sacrificing opportunity to profit from low ones.
Households do not buy their electricity from markets but big companies do.
This thesis focuses on the NordPool market funded in Norway 1991.

Since the liberalization of the market started just about 20 years ago the field
is quite new. But the concepts of options and derivatives are well researched
by now in finance and the idea is to start off by seeing what theory can be
recycled and the goal is to construct a stochastic model of the spot price.
This thesis uses the model proposed by Tino Kluge [1] (University of Oxford)
in his doctoral thesis from 2006 and this thesis is mainly written based on
Kluge’s work and some theory from Björk [2]. The spot price market is
modelled after a simple mean-reverting process with spikes and a seasonal
component. Spikes usually happen when the demand is getting close to the
maximum supply of the market and are unique for the electricity market.

This thesis starts off with a technical description of the Nordpool market in
Chapter 2. In Chapter 3 a model of the spot price is proposed and calibrated
after historical market data, which is the main topic of the thesis. Then
some applications of the model are provided in Chapter 4 and future prices
are predicated. Finally in Chapter 5 conclusions are drawn and future work
suggested.

2 Electricity markets

The first goal of this chapter is to look at the differences between the elec-
tricity market and the stock market to determine what known theory from
the well researched financial area can be recycled. Secondly a more firm
description of the electricity spot and derivative market is given.

3
The assumption of no arbitrage is just like in the financial market the fun-
damental principle which all electricity market options will be based upon.

Underlying unit: The underlying are simply ”units of electricity” and are
mostly bought in units of 1 MWH.

Production and Consumption: In the share market the amount of shares

remains constant (unless new shares are issued) which is not the case in
the electrical market. In the electrical market ”shares” are consumed when
bought since storing electricity is not possible (maybe hypothetically but not
practically). Based on microeconomic theories the long-term price should
move towards the production cost. This is why mean-reverting models are
mainly used to model the electricity price since the production cost doesn’t
change much while in the share market some growth is assumed.

Inability to store: Electricity is considered a non-storable unit, also called

a pure flow variable (measured in energy per time).

The inability to store electricity makes hedging not possible which leads to
the market being automatically incomplete and independent of the stochas-
tic process used to model the underlying. In other words the risk neutral
probability measure Q is not unique.

Since production and consumption have to be in balance all the time, to

avoid power black outs, the price will experience seasonalities. In the event
of a power plant failure the maximum supply could drop below the demand
of the market and price spikes will occur. Due to this, supply and demand
models are common but wont be used in this thesis. Instead the stochastic
model used will have a spike process included.

2.1 The spot market

NordPool was funded in Norway 1991 when the Parliament of Norway de-
cided to deregulate the power trading market. In 1996 Sweden joined the
market and thus NordPool became the world’s first international power ex-
change market. Eventually more countries also became a part of the Nord-
Pool market, Finland (1998), Denmark (Western in 1999, eastern 2000) and

4
in 2002 Nord Pool Spot were established. Nord Pool Spot also includes Esto-
nia, Latvia and Lithuania. Since 2010 Nord Pool Spot is responsible for the
day-ahead market(the spot market) and NASDAQ OMX for the forward con-
tract market. More than 70 % of all electrical energy in the Nordic countries
are traded through NordPool as of today.

To be able to deliver the energy, transmission grids are provided by NordPool.

These transmission grids are monopolistically operated and the prices are set
to reflect the maintenance cost and the energy transportation loss. In Sweden
Svenska Kraftnät, which is owned by the Swedish government, operates the
transmission grid. Svenska Kraftnät originally owned 50 % of NordPool
and today own 20 % of Nord Pool Spot. The transmission grid operating
companies are responsible for ensuring that the same amount energy that is
sold is delivered to the buyer and will have to buy the lost energy from the
spot market to compensate.

To be able to sell energy on the NordPool market a bond will have to be

pledged to a security bank account. The bidding areas are divided into sev-
eral regions, e.g. Sweden consists of four different regions, Luleå, Sundsvall,
Stockholm and Malmö. The power companies will daily submit their hourly
prices and quantity to be sold to NordPool for the upcoming day. NordPool
then sets the hourly spot price for the following day using the supply-demand
principle.

The daily averages, i.e. base load contracts are usually the underlying prod-
uct in contracts. Even though the spot price varies a lot during the day, the
daily average is mostly the underlying product for contracts. The maximum
price of the day can be as high as twice of the minimum. The contracts sold
on the Nasdaq OMX market are of the duration of a week, month, quar-
ter or year and the delivery period is as long as four years for the yearlong
contracts.

Due to the market being incomplete and hedging not possible one could think
the market would be more risky for sellers compared to the stock market.
But since producers produce electricity at an almost known future cost the
risk is almost eliminated in exchange for the possibility for high profits with
contracts.

5
In 2008 hydro power were 98.5 % of Norway’s and 45 % of Sweden’s energy
production. This leads to there being a huge dependence on the weather.
The model proposed however is solely based upon data without trying to
understand the mechanics behind the price.

Figure 1: The daily spot price starting at first of January 2012.

In Figure 1 the daily spot market price can be seen from 1 January 2012 to
May 2014. First of all the spot price seems to lack any positive drift, so using
a geometric Brownian motion (commonly used in the financial market) for
modelling the spot price is not feasible. Instead a mean-reverting behaviour
is shown and this property will be the base for the stochastic process used.
A strong yearly seasonality is shown, which could be expected in cold Nordic
countries where there are a high demand for heating during the winter. From
Figure 2 a strong weekly seasonality is seen where the price goes down during
weekends and peak during the working days, e.g. day 596 is a Sunday. Several
spikes can also be seen, both positive and even some negative ones, in this
thesis’ model the negative ones will be ignored. The positive spikes are
mostly explained by some power plant temporary being out of function and
the supply and demand principle. Notice how fast the price during spikes
reverts back to normal levels.

6
Figure 2: The daily spot price starting at first of January 2012 zoomed in to
easier examine the weekly seasonality.

3 Spot price model and parameter estima-

tion

There are two main approaches to model a stochastic process. The first one
is trying to understand the underlying mechanics, how has the weather been,
have any new laws been implemented etcetera. The other one, which will be
used, is to simply look at the available data and try to fit a mathematical
model to it.

Considering the observations made in the last chapter a natural model of the
daily spot-price market would be of the form

dXt = −αXt dt + σdWt

(1)
St = exp(f (t) + Xt )

where f (t) is a seasonal term and Xt an Ornstein-Uhlenbeck process. How-

ever this model won’t be able to deal with the spikes observed in figure 1. A

7
spike process will be added on the form suggested by Kluge and the model
used will be of the form
dXt = −αXt dt + σdWt
dYt = −βYt− dt + Jt dNt (2)
St = exp(f (t) + Xt + Yt )
where Jt is an i.i.d. process representing the jump size, Nt the time in
between the jumps and β a parameter describing how fast the spikes revert
back to the normal level. Wt , Nt and Jt are assumed to be independent. For
simplicity and due to only assuming positive spikes the jump sizes Jt will
be assumed to be exponential and the jump frequency Nt to be a Poisson
process.

Estimating f (t), Xt and Yt from just knowing historical spot price values
St leads to the estimation being non-trivial. However it feels natural to
estimate the deterministic seasonal component first and by removing the
seasonal component of St try to estimate the Ornstein-Uhlenbeck process.
Finally using the estimate of Xt one could identify extreme outliners and use
these to approximate spikes.

3.1 The seasonal part

For the seasonal part some assumptions of the function f (t) needs to be
made. From the observations in chapter two there were strong weekly and
yearly seasonality and the function is defined to be of the form
6
X
f (t) = c + ai cos(2πγi t) + bi sin(2πγi t), (3)
i=1

where γ1 = 1, γ2 = 2, γ3 = 4, γ4 = 365/7, γ5 = 2x365/7 and γ6 = 4x365/7

to represent weekly and yearly seasonality. To estimate the parameters the
model is assumed to be of the form
St = exp(f (t))
and a least-square method is used by minimizing
X
(ln(St ) − f (t))2 .

8
Figure 3: The least-square estimates with and without outliners excluded
plotted against the spot price data.

Due to several spikes in the price an algorithm excluding outliners may be

preferred and can be seen in Figure 3.

3.2 The Ornstein-Uhlenbeck process

Since an estimate of the seasonal function f (t) is acquired the right hand
side of
ln(St ) − f (t) = Xt + Yt . (4)
is left to be estimated. The idea is to ignore the spike process Yt for now and
estimate the Ornstein-Uhlenbeck process Xt . If Xt is estimated one can find
the extreme outliners and use these to estimate Yt . The deseasonalized-log
values can be seen in Figure 4.

9
 Figure 4: The log values of the spot price with seasonality removed.

Definition 3.1 (Ornstein-Uhlenbeck process). A zero-mean Ornstein-Uhlenbeck

process is a stochastic process satisfying the following Stochastic Differential
Equation (SDE):
dXt = −αXt dt + σdWt , (5)
where α is the mean-reversion rate, σ the volatility and Wt is a standard
Brownian motion.

To be able to estimate the parameters α and σ one first need to know the
solution of (5).

Theorem 3.1 (Ito’s Lemma). For an Ito drift-diffusion process

dXt = µt dt + σt dWt

a twice differentiable function f (t, x) has the differential

1 2 ∂ 2f
 
∂f ∂f ∂f
df (Xt , t) = + µt + σt 2 dt + σt dWt
∂t ∂x 2 ∂x ∂x

10
Theorem 3.2. The solution to the SDE (5) defining the zero-mean Ornstein-
Uhlenbeck process is given by
Z t
−αt
Xt = X 0 e + σeα(s−t) dWs , (6)
0

for 0 ≤ s ≤ t.

Proof. By applying Ito’s lemma to the function

f (Xt , t) = Xt eαt

one get
df (Xt , t) = αXt eαt dt + eαt dXt = σeαt dWt
assuming µ = 0. Integration from 0 to t then gives
Z t
αt
Xt e = X0 + σe−αt dWs
0

and hence Z t
−αt
Xt = X0 e + σeα(s−t) dWs .
0

The solution of the OU-process is later on used for simulations of the model.
Using Theorem 3.2 and the following theorem about Ito integrals one can
find a conditional distribution of change for an OU-process.

Theorem 3.3. [Ito integral] The integral

Z t
f (t)dWt
0

where Wt is a standard Brownian motion has expected value 0 and the vari-
ance Z t
f (t)2 dt.
0

11
Proof. The definition of an Ito integral is
Z t X
I := f (t)dWt = f (ti )(Wti+1 − Wti ). (7)
0 ∆ti →0

Brownian motion has the property that increments in time are independent
with the expected value zero and the variance ∆ti . So the expected value of
(7) is given by
X X
EI = E f (ti )(Wti+1 − Wti ) = f (ti )E(Wti+1 − Wti ) = 0.
∆ti →0 ∆ti →0

The variance is given by

X
E(I 2 ) − (EI)2 = E(I 2 ) = E f (ti )2 (Wti+1 − Wti )(Wtj+1 − Wtj ) =
t,j
X X Z t
2 2 2
f (ti ) E(Wti+1 − Wti ) = f (ti ) ∆ti = f (t)2 dt.
∆ti →0 ∆ti →0 0

Using that Brownian motion increments are independent with variance t.

Theorem 3.4 (Conditional distribution of change for an OU-process). Given

a zero-mean OU-process of the (5) the conditional distribution of change is
given by
σ2
 
−α∆t −2α∆t
Xt+∆t − Xt e ∼ N 0, (1 − e ) . (8)
2α

Proof. From (6) the following holds

Z t+∆t Z t
−α∆t −α∆t α(s−t) −α∆t
Xt+∆t − Xt e = σe e dWs − σe eα(s−t) dWs .
0 0

The result is then acquired from Theorem 3.3.

From knowing the conditional distribution of change for the OU-process a

Maximum likelihood estimate can be derived.

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Theorem 3.5. likelihood for an OU-process] Given a set of observations
(S0 , S1 , ..., Sn ), the MLE estimation for a zero-mean Ornstein-Uhlenbeck pro-
cess of the form
dXt = −αXt dt + σdWt
is given by  
1 Sxy
α = − log
δ Sxx
1 (9)
σ̂ 2 = Syy − 2e−αδ Sxy + e−2αδ Sxx


n
2α
σ 2 = σ̂ 2
1 − e−2αδ
where δ is the time step and
n
X
2
Sxx = Si−1
i=1
Xn
Sxy = Si−1 Si
i=1
Xn
Syy = Si2 .
i=1

Proof. A short version of the proof will be given. The conditional density
function can be derived using the method used in Theorem 3.4 and gives

(Si − Si−1 e−αδ )2

 
1
f (Si+1 |Si ; α, σ̂) = √ exp − (10)
2πσ̂ 2 2σ̂ 2

which gives the log-likelihood function

n
X
L(α, σ̂) = ln f (Si+1 |Si ; α, σ̂) =
i=1
n (11)
n 1 X 2
− ln(2π) − n ln(σ̂) − 2 Si − Si−1 e−αδ .
2 2σ̂ i=1

The maximum of (11) is found where the partials derivatives are zero, which

13
gives the MLE estimates of α and σ̂:
n
∂L(α, σ̂) δe−αδ X 
Si Si−1 − e−αδ Si−1
2

=− 2 =0
∂α σ̂ i=1
Pn (12)
1 Si Si−1
α = − ln Pi=1 n 2
δ i=1 Si−1

and n
∂L(α, σ̂) n 1 X 2
= − 3 Si − e−αδ Si−1 = 0
∂ σ̂ σ̂ σ̂ i=1
n (13)
1 X 2
σ̂ 2 = Si − e−αδ Si−1 = 0
n i=1
which equals the equations in (9). For a rigorous proof see Sitmo [3].

Figure 5: The change each time step for the deseasonalized logarithmic price.

Using the Maximum Likelihood Estimation from Theorem 3.5 a first param-
eter estimation can be acquired. Extreme outliners are then excluded and a
new estimation is done, this process is repeated three times. The changes in

14
Figure 6: The change each time step for the conditioned deseasonalized log-
arithmic price.

Table 1: Estimated parameter values for the Ornstein-Uhlenbeck process

Parameter Estimate
α 29.4568
σ 1.4723

each step and a 99.7 % confidence interval can be seen in Figure 5 and the
conditioned change in time can be seen in Figure 6 after one iteration. This
method gives us the parameters in Table 1.

3.3 The Spike Process

From the algorithm used in the last chapter to estimate the Ornstein-Uhlenbeck
process parameters, the outliners are saved and used to estimate the spike

15
process. The spike process Yt is defined to be

dYt = −βYt− dt + Jt dNt (14)

where Jt is exponentially distributed, Nt Poisson distributed and β the mean

reversion rate. The mean reversion rate decides how fast the spike diminishes
and will be determined completely by some educated guessing. Here β is set
to β = 200/365 which causes the spikes to have a half-life of one day.

Table 2: Estimated parameter values for the spikes process

Parameter Estimate
Exp(µ) 0.3122
P o(λ) 106.8000
β 200/365

Figure 7: A realization of the spike process with estimated parameter values.

In total 5 positive spikes were identified and it is easy to estimate the param-
eters µ and λ for the exponential and Poisson distributions. The estimated

16
values can be seen in Table 2 and a realization of the spike model can be
seen in Figure 7.

There is however one big flaw with the method used, only big spike values can
be identified and with the exponential parameter obtained, spikes simulated
can become bigger than realistically possible. To avoid unrealistic results an
upper limit of three times the expected value can be set for the spikes to
avoid bizarre predictions, this limit was set after running several simulations
and observing the model behaviour.

4 The calibrated model

A full calibrated model has now been obtained. A quick way to see if the
model is somehow realistic is to compare some realizations against the his-
torical market data. A realizations can be seen in Figure 8.

Figure 8: A realization of the calibrated model plotted against the market

data.

17
Obviously it cannot be said that the model is good from comparing one
realization with the old data but at least one can say that the estimation
methods seemingly are correct.

4.1 Monte Carlo predictions

To be able to get a good predication of how the future spot price will develop
a Monte Carlo method is used. Several realizations are made and the average
will be the best prediction. Due to spikes being quite rare (occurring after
a Poisson model with λ = 106.8) many iterations will be needed to give a
fair representation of the spike processes. A rough estimation is that each
day will have a spike every 100th simulation so to simulate them correctly
around 100 000 iterations would be needed at least.

Figure 9: A predication made after one iteration of the calibrated model.

In Figure 9 and Figure 10 predictions after one and 100 000 Monte Carlo
iterations can be seen. Due to the OU-process being mean-reverting with
zero-mean one could expect the price to move towards the seasonal estimation

18
Figure 10: A predication made after 100 000 Monte Carlo iterations of the
calibrated model.

after a while and that is also what is happening. Due to the spike process
the model prediction is however slightly above the seasonal.

4.2 Forward pricing

The standard formula for pricing forward contracts in the stock market is
not applicable in the electrical market due to there being no price of risk
and no possibility to store the underlying unit traded. Instead the market
practice is to set the price to be the expected value of the spot price for that
day. Forwards lasting a period longer than a day is priced to be the weighted
average during the whole period.

In figure 11 some week and month long forward contracts are priced. The

19
Figure 11: Pricing of forward contracts made after 100 000 Monte Carlo
iterations of the calibrated model with the same weight for every day.

forward prices are here set to

n−1
1X
F = wi E[ST +i ] (15)
w i=0

where wi is the weight of howPmuch electricity is to be bought that day

n−1
(measured in 1 MWH), w = i=0 wi , T the delivery period and n is the
amount of days the contract covers.

5 Discussion and conclusions

The model proposed in this thesis is not perfect but manages to mimic the
main characteristics of the electricity market well, the seasonal part, the
mean-reverting behaviour and the spikes are all accounted for. To improve
the model some sort of weather prediction added would most likely cause

20
the best improvement since the Nordic countries, Norway and Sweden in
particular, are very dependent on hydro-power hence downfall has a huge
impact on the electricity production. Also warm days, especially during the
weekends, can cause a drop in consumption from private consumers. Even if
industry is responsible for most of the consumption a small drop in demand
can cause a big drop in the price.

If an improvement to the model is desired without trying to understand the

underlying mechanics adding either stochastic or seasonal dependent volatil-
ity might be the most natural next step. Also adding some randomness to
the seasonality part or dependence between the stochastic processes, now
assumed to be independent of each other, might give some improvements.
The problem with this is that even if the historical data might fit better to
our model, calibrating the model is becoming much harder and might not
give better results.

As seen from the Monte Carlo predictions in Figure 10 the long term pre-
dictions moves towards the seasonal function. If the goal of the model is to
simply price long term forward contracts an interpolation model might be to
prefer and is also easier to calibrate. However information of the path of the
process is then lost which is needed in the case of pricing Swing Options that
are commonly used in the electricity market. Swing Options gives the buyer
the possibility to change the amount of electricity bought several times and
introduces a path-dependency.

The forward prices predicated from this model were slightly above the mar-
kets. This could be because the market prediction were more local (the price
has been low the last month) or due to risk averse behaviour of the sellers.
Also the model is calibrated after not even 2.5 years of data, in Kluge’s thesis
10 years of data were used. The reason for this is that to get access to more
data from NordPool an expensive membership is required.

21
References
[1] Kluge, T Pricing Swing Options and other Electricity Derivatives. PhD
thesis, University of Oxford 2006.

[2] Björk, T Arbitrage Theory in Continuous Time. Oxford University Press,

3rd edition 2009.

[3] Sitmo, Calibrating the Ornstein-Uhlenbeck (Vasicek) model, 2014. Avail-

able online.

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