Intermittently coupled electricity markets

Auctions of transmission rights between neighbouring countries are becoming increasingly active. In a parallel development, the introduction of market coupling frequently leads to smaller price differences between such countries. Indeed, if two countries are completely coupled, the price of a given hour of electricity will be identical in each country, resulting in a price spread of zero. Clearly, it is important to take this market coupling into account when evaluating transmission rights, as neglecting it would lead to a significant overvaluation of these rights. In order to address this issue, we introduce a general regime-switching mechanism that can be applied to many models in the literature. In particular, we focus on extending the model proposed by Cartea and González-Pedraz (2012). We describe the model estimation procedure in detail, and compare model and market prices of European spread options. We observe a dramatic paradigm shift in our data set at the end of the summer of 2021, and show that this shift has a strong effect on the model parameters. We also see that the reliable pricing and trading of spread options becomes problematic in such a volatile and uncertain market environment.