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A fractional cointegration analysis of European electricity spot prices

This study extends the existing literature about European electricity market integration by adopting a fractional co-integration analysis and providing empirical evidence that the classical unit root test framework may be inadequate because of long range dependencies in electricity spot prices.

Author(s): Professor Lilian De Menezes - Cass Business School; Melanie Houllier - Cass Business School

At present the European electricity market liberalisation is the world's most extensive cross-jurisdiction reform of the electricity sector. The key characteristics of modern European power markets are unbundling of vertical integration, competition, free market entry and an independent national regulator who ensures third party access. Although most market design features were implemented in a similar way, the markets are still characterised by important differences in physical (e.g. market shares, capacity) and technological structure. Given the legislative changes, analysis of common dynamics and convergence of electricity prices can be used to answer the question whether or not the goal of the EU policy of one supranational, competitive market is being achieved. A competitive market would result in the convergence of prices towards one equilibrium price. Differing long and short-term price behaviour would suggest that structural differences at the national level remain dominant and that arbitrage opportunities are limited.

Most previous studies concluded, that there is some form of integration among electricity spot markets. However, the assessment of whether or not the law of one price and a supranational electricity market is being achieved remains vague. A reason for the weak empirical support of the law of one price in deregulated electricity markets can be the fact previous studies assumed the order of integration of the equilibrium error is either zero or one, which would have limited their ability to examine long run cointegrated relationships.

With this paper we aim to verify this potential reason by conducting a fractional cointegration analysis, which allows the order of integration to be any real number. We investigate the complete sample as well as specific hours in order to assess the extent of integration. We present our methodology, followed by the data, and then the empirical results are reported and summarised. The paper concludes with a discussion of the results and their implications for researchers and practitioners.

This research was presented at the 9th International Conference on the European Energy Market (EEM12, Florence) and is also a research in progress. The full paper can be downloaded via the link below.

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{A fractional cointegration analysis of European electricity spot prices}{https://www.cass.city.ac.uk/__data/assets/pdf_file/0007/363616/fractional-cointegration-europe-electricity-cass-knowledge.pdf}
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