Modelling Dependence of Extreme Price Observations in Connected Electricity Markets Using Tail Copulas

Spot electricity prices are very volatile, particularly due to the fact that electricity cannot be economically stored and requires immediate delivery. However, the inability to store electricity means that fluctuations in demand and supply are often transmitted directly into spot prices of electricity, which leads to occasional extreme price observations, so called price spikes. These price spikes constitute a major source of price risk to market participants. More importantly, for those operating in several regional markets simultaneously, the probability of simultaneous extreme price observations, usually called tail dependence, is of great importance in implementing adequate hedging strategies. For this purpose, the problem of modelling the joint occurrence of extreme price observations in the Australian Electricity Market is considered. We suggest a new method to capture the dependence of extreme price observations across several regional markets. It uses the concept of tail copulas as models for different scenarios of joint extreme outcome. For risk management purposes, our findings point out the substantial implications which the joint extreme price observations may have for hedging decisions of market participants, and therefore, also for the pricing of electricity derivatives like futures and option contracts