Modeling the exact convergence of electricity prices in interconnected markets

The liberalization of energy markets worldwide during recent decades has introduced severe implications on the price formation in these markets. Especially within the European day-ahead electricity markets, increased physical connections between different market areas and a joint effort on optimizing the aggregate social welfare have led to highly connected markets. Consequently, observing the exact same hourly day-ahead prices - exact price convergence - for two or more interconnected electricity markets in Europe happens frequently, which affects the modeling of such prices and in turn the valuation of derivatives written on prices from such interconnected market areas. In this paper, we propose a continuous-time model that takes this feature into account in a reduced-form manner. We discuss the properties of the model and propose an estimation procedure. Furthermore, the properties of the model reveals that analytical prices are attainable for e.g. forwards and spread options.