Hybrid Bottom-Up/Top-Down Modeling of Prices in Deregulated Wholesale Power Markets

“Top-down” models, based on observation of market price patterns, may be used to forecast prices in competitive electricity markets, once a reasonable track record is available and provided the market structure is stable. But many studies relate to potential changes in market structure, while prices in hydro-dominated markets are driven by inflow fluctuations and reservoir management strategies, operating over such a long timescale that an adequate track record may not be available for decades, by which time the system itself will be very different. “Bottom-up” analysis can readily model structural change and hydro variation, but must make assumptions about fundamental system data, commercial drivers, and rational optimizing behavior that leave significant unexplained price volatility. Here we describe a technique for fitting a hybrid model, in which a “top-down” approach is used to estimate parameters for a simplified “bottom-up” model of participant behavior, from market data, along with a stochastic process describing residual price volatility. This fitted model is then used to simulate market behavior as fundamental parameters vary. We briefly survey actual and potential applications in other markets, with differing characteristics, but mainly illustrate the application of this hybrid approach to the hydro-dominated New Zealand Electricity Market, where participant behavior can be largely explained by fitted “marginal water value curves.” A second application of a hybrid model, to the Australian National Electricity Market, is also provided.