Regime jumps in electricity prices

Many countries are liberalizing their energy markets. Participants in these markets are exposed to market risk due to the characteristics of electricity price dynamics. Electricity prices are known to be mean-reverting very volatile and subject to frequent spikes. Models that describe the dynamics of electricity prices should incorporate these characteristics. In order to capture the price spikes, many researchers have introduced stochastic jump processes, but we argue and show that this specification might lead to potential problems with specifying the true amount of mean-reversion within the process. In this paper, we propose a regime-switching model that models price spikes separated from normal mean-reverting prices.