A regime-switching copula approach to modeling day-ahead prices in coupled electricity markets

Highlights: • The joint behavior of electricity prices in interconnected markets is investigated. • A regime–switching AR–GARCH copula model is proposed. • Strong in– and out–of–sample results are obtained with the modeling framework. • We find evidence of heavy tails and tail dependence. • We apply the modeling framework to option pricing and the evaluation of tail risk. - Abstract: The recent price coupling of many European electricity markets has triggered a fundamental change in the interaction of day-ahead prices, challenging additionally the modeling of the joint behavior of prices in interconnected markets. In this paper we propose a regime-switching AR–GARCH copula to model pairs of day-ahead electricity prices in coupled European markets. While capturing key stylized facts empirically substantiated in the literature, this model easily allows us to 1) deviate from the assumption of normal margins and 2) include a more detailed description of the dependence between prices. We base our empirical study on four pairs of prices, namely Germany–France, Germany–Netherlands, Netherlands–Belgium and Germany–Western Denmark. We find that the marginal dynamics are better described by the flexible skew t distribution than the benchmark normal distribution. Also, we find significant evidence of tail dependence in all pairs of interconnected areas we consider. As a first application of the proposed model, we consider the pricing of financial transmission rights, and highlight how the choice of marginal distributions and copula impacts prices. As a second application we consider the forecasting of tail quantiles, and evaluate the out-of-sample performance of competing models.