Modeling the Impact of Temperature Variations on Electricity Prices

In this paper, we present an innovative electricity spot price model, wherein the prices explicitly depend on outdoor temperature. The proposed arithmetic multi-factor approach captures numerous stylized facts of empirical electricity price behavior like seasonal variations, time-dependent volatilities, mean-reversion to a stochastically-varying periodic function, price jumps with time-dependent amplitudes and frequencies, as well as heavy-tailed return distributions. In our setup, the temperature variations are modeled by an exogenous stochastic process which is independent of the electricity spot price. Nevertheless, though being mathematically uncorrelated, the spot and temperature process behave like correlated entities. Based on this approach, we infer pricing formulas for diverse electricity and temperature futures contracts. We also deduce minimal variance hedging portfolios in the underlying electricity-temperature market and investigate the pricing of related derivatives under weather forecasts modeled by an initially enlarged filtration