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A Spot Price's Model for Electricity in the Colombian Market Using Markov Chains and Mean Reversion - An Approach for Including the ENSO Effects on Prices

For many countries located around the equatorial region, climate phenomenon such as El Nino southern oscillation or ENSO has enormous impact on their economies. In the case of countries with a high degree of dependency on water resources for energy generation, the impact of ENSO has been observed mainly on the availability of water, the effective generating capacity, the ability to provide enough energy for the demand and electricity prices. Efforts has been made in order to measure and hedge the risk associated with electricity scarcity, but there is a lack of proper tools for price modeling under the unique composition of electricity markets in countries such as Colombia, Brazil and other emerging countries whose economies depend greatly on water generated electricity. This paper presents a model for the simulation of electricity spot prices for the Colombian market with regime changes, mean reversion and Markov chains. The main goal of this article is to show a model which could represent the sustained structural changes that occur in the electricity market when there is an ENSO. This model is expected to help improving hedging strategies, market efficiency and the general understanding of the effect of ENSO on the market. A daily average price's series was used to calibrate the model and conclusions are drawn for this particular case. This work could be the starting point for future projects tending to develop option valuation models for the reliability charge, energy planning and risk management for the electricity market.