A Regime-Switching Copula Approach to Modeling Day-Ahead Prices in Coupled Electricity Markets (Pre-print)

The recent price coupling of many European electricity markets has triggered a fundamental change in the interaction of day-ahead prices, challenging additionally the modeling of the joint behavior of prices in interconnected markets. In this paper we propose a regime-switching AR-GARCH copula to model pairs of day-ahead electricity prices in coupled European markets. While capturing key stylized facts empirically substantiated in the literature, this model easily allows us to 1) deviate from the assumption of normal margins and 2) include a more detailed description of the dependence between prices. We base our empirical study on four pairs of prices, namely Germany-France, Germany-Netherlands, Netherlands-Belgium and Germany-Western Denmark. We find that the marginal dynamics are better described by the flexible skew t distribution than the benchmark normal distribution. Also, we find significant evidence of tail dependence in all pairs of interconnected areas we consider. As applications of the proposed empirical model, we consider the pricing of financial transmission rights and the forecasting of tail quantiles. In both applications, we highlight the effects of the distributional assumptions for the margins and the tail dependence.