Price volatility in commodity markets with restricted participation

Highlights: • Price volatility may increase significantly in sequential commodity markets • We analyze price volatility based on the example of German electricity markets • We develop a theoretical model and feed the results into an empirical validation • We identify restricted market participation as a driver of increasing price volatility • Welfare losses in German electricity markets may be reduced if markets are coupled -- Abstract: In commodity markets, price volatility may rise significantly if the product granularity increases. To gain insights into the underlying drivers, we analyze price volatility based on the example of German electricity markets. We develop a theoretical model to reproduce the price formation in the day-ahead and intraday auction which are sequential short-term electricity markets with 60-minute and 15-minute products. As cross-border trade is allowed in the day-ahead but not in the intraday auction, the model accounts for the impact of restricted market participation. The theoretical model is then transferred into an empirical analysis to first validate the modeling approach and second to comparatively assess the impact of increasing product granularity and restricted market participation. The empirical results indicate that the disproportional rise in quarter-hourly price volatility is mainly triggered by limited market participation and not only by the high volatility of renewable supply and demand. Since restricted market participation refers to a lack of market coupling, we derive a proxy for efficiency losses ranging from EUR 55 million to EUR 108 million that may be reduced if markets are coupled.