Regime switches induced by supply–demand equilibrium: a model for power-price dynamics

Regime-switching models can be used to describe stochastic movements of electricity prices in deregulated markets. This paper shows that regime-switching dynamics arise quite naturally in an equilibrium context in which the functional form of the supply curve is described by a two-state Markov process. This mechanism is responsible for random switches between regimes and it allows one to describe the main features of the price-formation process. With the interplay between demand and supply, the proposed methodology can be used to capture shortages in electricity generation, forced outages, and peaks in electricity demand. As an example of application, a two-regime model specification is proposed, and it will be shown that the empirical analysis, performed by estimating using the model on the California power market, offers an interesting agreement with observed data.