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IEEE TRANSACTIONS ON POWER SYSTEMS, VOL. 20, NO.

2, MAY 2005 867

A GARCH Forecasting Model to Predict Day-Ahead


Electricity Prices
Reinaldo C. Garcia, Javier Contreras, Senior Member, IEEE, Marco van Akkeren, and João Batista C. Garcia

Abstract—Price forecasting is becoming increasingly relevant to so that they can hedge against pool price volatility through bi-
producers and consumers in the new competitive electric power lateral contracts. Therefore, a good knowledge of future pool
markets. Both for spot markets and long-term contracts, price prices is very useful in valuating bilateral contracts more accu-
forecasts are necessary to develop bidding strategies or negotia-
tion skills in order to maximize profits. This paper provides an rately.
approach to predict next-day electricity prices based on the Gen- In recent years, several methods have been applied to predict
eralized Autoregressive Conditional Heteroskedastic (GARCH) prices in electricity markets. For example, the Transfer Function
methodology that is already being used to analyze time series data [2] and autoregressive intergrated moving average (ARIMA)
in general. A detailed explanation of GARCH models is presented models [3], [4] have been tested in the Spanish and the Norwe-
and empirical results from the mainland Spain and California
deregulated electricity-markets are discussed. gian markets. In addition, Artificial Neural Networks (ANNs)
have been applied to both the England and Wales pool [5] as
Index Terms—Electricity markets, forecasting, GARCH models, well as the Victorian wholesale market in Australia [6]. Other
time series analysis, volatility.
techniques, such as Fourier Transform [7] and stochastic mod-
eling [8] have addressed the same problem.
I. INTRODUCTION As mentioned earlier, one key aspect of pool prices is
their volatility, at least during certain periods. Note that price
P RICE forecasting has become a very valuable tool in the
current upheaval of electricity-market deregulation.
Companies that trade in electricity markets make extensive
volatility is also very important to calculate annual average
prices in order to valuate contract prices.
use of price prediction techniques either to bid or to hedge Spot price volatility has been recently studied in several pub-
against volatility. When bidding in a pool system, the market lications. Benini et al. [9] have analyzed several markets, such
as Spain, California, England and Wales, and the PJM system.
participants are requested to express their bids in terms of prices
Mount [10] has claimed that a uniform auction worsens this
and quantities. Since bids are accepted in order of increasing
problem as compared to a discriminatory auction in the Eng-
prices until total demand is met, a company that is able to fore-
land & Wales system. The Californian market has also served as
cast pool prices can adjust its own price/production schedule
a benchmark to apply Value-at-Risk models [11] or stochastic
depending on hourly pool prices and its own production costs
linear regression models [12].
[1].
Generalized Autoregressive Conditional Heteroskedastic
Another instrument to facilitate market trading is the bilateral
(GARCH) models [13], [14] consider the moments of a time
contract system. In this setting, a buyer and seller agree on a cer-
series as variant (i.e., the error term: real value minus forecasted
tain amount to be transferred through the network at a specific
value does not have zero mean and constant variance as with an
fixed price. This price is agreed upon by both sides beforehand
ARIMA process). The error term is now assumed to be serially
and is also based on price predictions. Most of the deregulated
correlated and can be modeled by an Auto Regressive (AR)
electricity markets use a mixed bag of pool and bilateral con-
process. Thus, a GARCH process can measure the implied
tracts. Companies have to optimize their production schedules
volatility of a time series due to price spikes. For example,
California experienced huge price spikes during the summer of
2000 that led to the closure of the market [11], [12] until new
rules were developed.
Manuscript received December 23, 2003; revised September 7, 2004. This
work was supported in part by the Ministry of Science and Technology of Spain This paper focuses on day-ahead forecasts of electricity
and the European Union through Grant FEDER-CICYT 1FD97-1598. Paper no. prices with high volatility periods using a GARCH method-
TPWRS-00699-2003. ology approach. Our GARCH models provide 24-hour forecasts
R. C. Garcia is with the Department of Energy, Transportation, and Environ-
ment, German Institute of Economic Research, DIW, 14195 Berlin, Germany of the next day market clearing price based on historical data
(e-mail: rgarcia@diw.de). [15], [16]. To illustrate our model, price forecasts of the main-
J. Contreras is with the E.T.S. de Ingenieros Industriales, Universidad land Spain [17] and California [18] electricity markets are
de Castilla–La Mancha, 13071 Ciudad Real, Spain (e-mail: Javier.Contr-
eras@uclm.es). presented and discussed.
M. van Akkeren is with PMI Group, Walnut Creek, CA 94957 USA (e-mail: The paper is organized as follows. In Section II, the general
marco.vanakkeren@pmigroup.com). GARCH methodology applied to the Spanish and California
J. B. C. Garcia is with the Derivatives Group, Dexia Bank, Brussels, Belgium
(e-mail: joaobatista.crispinianogarcia@dexia.com). day-ahead markets is shown. Section III presents numerical re-
Digital Object Identifier 10.1109/TPWRS.2005.846044 sults of the simulations and Section IV states our conclusions.
0885-8950/$20.00 © 2005 IEEE
868 IEEE TRANSACTIONS ON POWER SYSTEMS, VOL. 20, NO. 2, MAY 2005

II. GARCH METHODOLOGY


The information recovery process in time series analysis uses
historical observations to derive estimates of current and fu-
ture values of the dependent variable. Among the most pop-
ular estimation techniques are the Maximum Likelihood (ML)
approach, which requires the availability of information on the
entire probability distribution, Generalized Method of Moments
(GMM), which reduces the informational requirements to spe-
cific moments of the data, and nonparametric procedures. Non-
linear neural network models represent a more modern esti-
mation technique which has gained popularity in recent years.
Given that the Gaussian distribution for the time series is satis-
fied, we adhere to the Box-Jenkins modeling approach of parsi-
mony, i.e., using the fewest model parameters as supported by
the data, to estimate an ARMA process with GARCH error com-
ponents.
The ARMA process includes components of both au-
toregressive and moving average terms and is defined as

(1)

or applying the backshift operator, , where , and Fig. 1. Flowchart of the GARCH methodology.
in general, , (1) can be represented as
As it can be easily seen from (5), any GARCH model
(2) where , i.e., a GARCH , becomes an ARCH
model. Therefore, in a GARCH model, as it incorporates mean
In traditional ARMA estimation, the basic assumptions on the reversion, the dynamics of can then be explained through past
error terms include zero mean and constant variance, or specif- volatility shocks .
ically (i) , (ii) , and (iii) , for The flowchart (i)-(v) in Fig. 1 shows how we obtain our
. In particular, the homoskedastic assumption (ii) of con- GARCH model for the Spanish and California markets:
stant variance, does not necessarily need to hold. The class of
models where the constant variance assumption does not hold is (i) A class of models is considered as-
named heteroskedastic. Our research has found that the gener- suming a certain hypothesis.
alized heteroskedastic error specification is strongly supported (ii) Based on data analysis, a subset of
by the hourly electricity price data applied in this work. This models is identified (i.e., in our case, a
specification significantly improves both goodness of fit and GARCH model).
out-of-sample predictive ability to estimate energy price move- (iii) The model parameters are estimated.
ments. (iv) If the model is validated using sta-
To accommodate the possibility of serial correlation in tistical hypothesis testing, then go to
volatility, the Autoregressive Conditional Heteroskedastic step (v); otherwise return to step (ii) to
(ARCH) class of models was introduced by Engle [19]. The refine the model.
ARCH model considers the conditional variance as time (v) The model parameters are defined and
dependent, out-of-sample forecasting can be initi-
ated.
(3)
In the following subsections, each step of the above scheme
An extended ARCH model called GARCH (Gener- is detailed.
alized Autoregressive Conditional Heteroskedastic) model was
proposed by Bollerslev [20] where takes the form A. Class of Models
In this step a general class of models is identified. This is car-
(4)
ried out by careful inspection of the main characteristics of the
where is basically a white noise process and, more hourly price series. In most competitive electricity markets, this
important series presents: high frequency, nonconstant mean and variance,
and multiple seasonality (corresponding to daily and weekly pe-
(5) riodicity, respectively), among others. These factors are among
the main ones applied when selecting the GARCH model. We
GARCIA et al.: GARCH FORECASTING MODEL TO PREDICT DAY-AHEAD ELECTRICITY PRICES 869

found that the class of ARMA processes with time-varying vari- step). The parameter estimation is based on maximizing a like-
ance component (GARCH models) represents the subgroup of lihood function for the available data (see [13] and [14]).
models on which we focus our analysis. During the parameter estimation procedure, it is possible that
Denoting by the electricity price at time , the proposed unusual observations that appear during high price-volatility pe-
ARMA model already described in (2) is the following one: riods affect the values of the parameters. As it is not possible to
know a priori when a crisis such as the California electricity one
(6) will happen, we have decided to use the real price data as it is
given without making any adjustment for the problem of out-
liers. With this approach, a more realistic modeling, estimation
where takes the GARCH form described in (4) and (5).
and forecasting procedure is achieved.
B. Subset of GARCH Models
D. Model Validation
A trial model, as seen in (6), must be identified for the price
In this step, rigorous statistical hypothesis testing is applied to
data. First, due to high volatility in the hourly electricity prices,
validate the model assumptions of the GARCH specification in
a logarithmic transformation is applied to the data set to smooth
step (i). The diagnosis checks verify the statistical significance
the volatility effect. Then, in a first trial, the observation of the
and assumptions of the parameters in the GARCH model and its
autocorrelation and partial autocorrelation plots of the price data
residuals (actual prices minus fitted values, as estimated in step
can help to make the selection of this first trial model. This
(ii)). Statistical tests on the residuals including the Ljung-Box
provides an insight both into seasonality of the data and the
statistic, and plots, such as the autocorrelation and partial au-
time-varying nature of volatility. Therefore, after a thorough
tocorrelation ones, are applied (see [13] and [14]). When vali-
analysis, the first trial model applied to all days and hours, in-
dating the model, we have analyzed the autocorrelation and par-
cluding weekdays and weekends, of the data set analyzed for the
tial autocorrelation of the residuals. We have also looked at the
Spanish and Californian markets is the following AR model:
values of the Ljung-Box statistics for different lags. Finally, we
have made sure that all lag values that are significant at conven-
tional levels have been added to the model. Moreover, when the
parameters are estimated, in general we have checked that all of
them are significant at the 10% level, according to the t-test.
If the statistical significance and the hypotheses tests on the
estimated parameters and the residuals are validated, the model
can be used to forecast prices. Otherwise, the data series con-
tains a certain structure that should be analyzed, refining the
specification in step (ii).

E. Applied Forecast
In step (iv), the validated model can be used to predict fu-
(7) ture price values that are usually 24 hours ahead. However, a
different time window can be applied in this step. This time
where is a GARCH(1,3) model, such that (4) and (5) are in window change is possible in simulations, as EViews provides
this case an estimate on the forecast error. Therefore, changing the time
window and applying the add-on EViews tool can improve the
(8)
forecast. During our analysis, for the Spanish market the av-
erage time window applied was 21 weeks, and for the California
(9)
market it was 15 weeks.
The results obtained applying the GARCH methodology de-
In successive trials, the same observation of the residuals ob- scribed above are presented in the next section.
tained in step (iii) which is described next (observed values
minus predicted values) can refine the structure of the functions III. CASE STUDIES. ANALYSIS OF THE RESULTS
in the model.
Therefore, to forecast the Spanish and the Californian hourly A. Applied Data and Obtained Models
electricity prices, once the five steps are applied, all the models In our empirical analysis, the proposed GARCH specifica-
are subsets of the model described in (7). tion is applied to the Spanish and California electricity data.
The Spanish data set consists of hourly electricity prices from
C. Parameter Estimation September 1, 1999 to November 30, 2000, whereas the Cali-
After the functional form of the model has been specified, the fornia data set consists of hourly electricity prices from January
unobservable parameters are estimated through Maximum Like- 1, 2000 through December 31, 2000.
lihood (ML) estimation. ML estimates are known to be asymp- The analysis is performed on both markets for twelve months
totically unbiased and efficient (the EViews software [21] is of the year taking into account low and high periods of elec-
used to estimate the parameters of the model in the previous tricity demand. The data set used in this research can be obtained
870 IEEE TRANSACTIONS ON POWER SYSTEMS, VOL. 20, NO. 2, MAY 2005

TABLE I TABLE II
SPANISH MARKET MEAN WEEK ERROR MWE (IN PERCENT) CALIFORNIAN MARKET MEAN WEEK ERROR MWE (IN PERCENT)

from the Spanish Market Operator [15] and the University of damping network effects are not present; finally, the exercise of
California Energy Institute [16] websites. market power by price-makers results in oscillating productions
The estimation results obtained for two of the GARCH model and prices for some hours, resulting in market uncertainty.
parameters described in (7)–(9) are presented in the Appendix . For the Spanish and Californian markets the MWE December
results are for the year 1999 and 2000, respectively, because of
B. Analysis of the Results the data set applied. All the other MWE results in Table I are for
the year 2000.
The results were obtained for the Mean Week Error (MWE)
The original GARCH model is more accurate in general than
and the Forecast Mean Square Error (FMSE) for the markets al-
a similar ARIMA model. Only during the months of very low
ready described. A detailed description on how to obtain MWE
volatility, such as February and May in Spain, and February,
and FMSE is shown next.
March and November in California, the ARIMA model shows
For the months under study, the average prediction error
slightly better performance than GARCH. From Tables I and
(a.p.e.) is computed for each day of the last week of the respec-
II it can be observed that adding the demand as an explana-
tive month, i.e.,
tory variable improves the forecast. Thus, GARCH with demand
outperforms ARIMA in every month. Furthermore, a GARCH
model performs better than an ARIMA model whenever price
(10)
spikes and market volatility occur.
A reasonably good performance can be observed from the
where and are the actual and forecasted hourly prices, re- results in Tables I and II when using GARCH. The MWE for
spectively. Then, the Mean Week Error, that averages the seven the Spanish market has an average value of 9.55%, where the
daily errors of the week, is calculated. Tables I and II show minimum MWE is 5.19% for May, and the maximum MWE is
the results for the MWE obtained when applying the GARCH 16.96% for December. The high error for the Spanish December
methodology for the Spanish and Californian markets, respec- month can be explained as the Spanish hourly electricity prices
tively. For validation purposes, we have included the effect of for the last week of December have an unusual behavior because
the demand in the GARCH methodology. The demand is added of the holidays during that time. Similarly, the MWE for the
as an extra variable in model (7), where both price and demand Californian market has an average value of 9.71%, where the
coefficients are included. We have also compared our results to minimum MWE is 5.76% for January, and the maximum MWE
an ARIMA model. The AR part of the model is similar to the is 15.91% for June, during the height of the California electricity
one in (7) and the MA part contains the first three error terms, as crisis.
in (9). For the Integrated part, hourly differencing was applied As can be seen from Table II, once California began to expe-
to the prices, after logarithmic transformation. rience the first blackouts following the collapse of its electricity
Due to the nature of this paper, other influential aspects such market (May 2000), the results obtained from the GARCH
as transmission line congestion and strategic behavior of the model were worse for California as compared to Spain. The
players have not been studied. Nevertheless, these aspects have same trend continued during the main period of the California
been explored in [1] using a simulation model. In [1] some con- crisis which extended for the following 4 mo until September
clusions are derived: the absence of network congestion making 2000.
cheaper generation available and lowering prices; if the net- A description of how the model mimics electricity price
work is not modeled, price oscillation becomes higher because volatility can be observed in Figs. 2–5.
GARCIA et al.: GARCH FORECASTING MODEL TO PREDICT DAY-AHEAD ELECTRICITY PRICES 871

Fig. 2. Results showing the electricity price volatility and its


forecast—Spanish market (June 24–30, 2000).
Fig. 4. Results of the price forecast for the week of the start of the California
crisis (May 19–28, 2000).

Fig. 3. Results showing the electricity price volatility and its


forecast—Spanish market (October 21–28, 2000).
Fig. 5. Results of the price forecast for the week during the height of the
California crisis (June 24–30, 2000).
The GARCH forecast of price volatility in the Spanish market
is shown in Figs. 2 and 3. In particular, Fig. 2 shows how the Another forecast with price volatility in the Spanish market
model works for the last week of June. This was the first time is also presented in Fig. 3, spanning from the October 21–28,
in 2000 in which there was high volatility in the Spanish market 2000. It can be seen how the price forecast obtained from our
with prices ranging from Euro12.37/MWh to Euro62.20/MWh. GARCH model follows quite closely the trend of the real price,
It can be observed that even though the model is not able to even when the real price showed a high volatility ranging from
forecast accurately the first high volatility peak occurred on June Euro12.37/MWh to Euro90.27/MWh. Table IV shows the errors
28, it was nevertheless able to reasonably follow the second high during the peak hours of October 25, 2000.
volatility peak observed on June 29. Similarly, Figs. 4 and 5 show the GARCH forecast for the
Table III shows the errors during the peak hours on June 29, California electricity prices. Fig. 4 presents the results for the
when the learning pattern occurs. Analyzing the Spanish re- period of the start of the California crisis, May 19–28, 2000.
sults presented in Tables III–IV, the error has an average value Even though the price was very volatile for that period, the
of 9.88% and 1.45% for the “peak hours” of June 29 and Oc- model was still able to follow the trend of the real price mainly
tober 25, respectively. Besides that, the maximum error in the after two peaks occurred on the May 22 and 23. Moreover, Fig. 5
two days described in Tables III and IV is about 17%, being a shows the results obtained from the model during the height of
reasonable result. the California crisis, the last week of June 2000.
872 IEEE TRANSACTIONS ON POWER SYSTEMS, VOL. 20, NO. 2, MAY 2005

TABLE III TABLE V


ERRORS DURING THE PEAK HOURS OF JUNE 29 IN THE SPANISH MARKET ERRORS DURING THE PEAK HOURS OF MAY 24 IN THE CALIFORNIAN MARKET

TABLE IV TABLE VI
ERRORS DURING THE PEAK HOURS OF OCTOBER 25 IN THE SPANISH MARKET ERRORS DURING THE PEAK HOURS OF JUNE 29 IN THE CALIFORNIAN MARKET

TABLE VII
Tables V and VI show the errors during the peak hours of May SQUARE ROOT OF THE FMSE
24 and June 29, 2000, respectively. Analyzing the Californian
results presented in the Tables V and VI, the error has an average
value of 9.29% and 11.01% for the “peak hours” of May 24 and
June 29, respectively. Moreover, for the California peak hours
in the two days described, the main problem occurs in hour 12
of June 29, where the forecasted error is 36.54%. Nevertheless,
it must be observed that there is a 78% variation in the hourly
price from hour 11 to hour 12 for the specific date, of June 29,
2000.
In Fig. 5, strong volatility in California market prices can be
observed for the last week of June with the prices varying from
a minimum of $25/MWh to a maximum of $750/MWh (the cap
electricity price in California at the time of its crisis). Fig. 5 is
quite illustrative in showing how GARCH models can be ap-
plied: observing the price trend from June 24 to 30, the ability
of the GARCH models to capture the hourly price volatility re-
ally improves. Analyzing the price volatility in Fig. 5, it can be
said that the MWE obtained from the model for this last week
of June, 15.91%, was reasonable, given the extreme variation of To conclude, Table VII presents the numerical results for the
the data. square root of the Forecast Mean Square Error (FMSE) of the
GARCIA et al.: GARCH FORECASTING MODEL TO PREDICT DAY-AHEAD ELECTRICITY PRICES 873

TABLE VIII IV. CONCLUSIONS


GARCH MODELS COEFFICIENTS
This paper has proposed a GARCH methodology to fore-
cast hourly prices in the deregulated electricity markets of Spain
and California. Average forecast errors using Spanish and Cal-
ifornian market data are around 9%, depending on the studied
month of the year. All the forecasts have been derived from sub-
sets of a GARCH general model applied to both markets, in-
cluding all hours, days, weekends and holidays.
Our GARCH model outperforms a general time series
ARIMA model when volatility and price spikes are present.
Moreover, adding the demand to the GARCH model as an
explanatory variable improves the performance of the method.
Thus, the errors are acceptable taking into account the com-
plex time series nature of electricity price data and the results
previously reported in the technical literature. In addition, the
ability of our model to predict extreme volatility has also been
tested in the Californian market.
In the future, improvements to the models, such as special
treatment for weekend data (calendar effect), and the inclusion
of exogenous variables (water storage, weather, etc.) will be ad-
dressed.

APPENDIX

This Appendix presents the coefficients obtained for the pa-


last week of every month evaluated as follows: rameters of the GARCH models for the Spanish and Californian
markets for the August 29, 2000. To obtain the parameters de-
scribed in Table VIII, a time window of 23 and 19 weeks was
FMSE (11) applied for the Spanish and Californian models, respectively.

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Reinaldo C. Garcia received the B.S. degree in mechanical aeronautical en- João Batista C. Garcia received the B.S. degree in electrical engineering from
gineering and the M.Sc. degree in operations research and transportation, both the Technological Institute of Aeronautics (ITA), São Jose dos Campos, Brazil,
from the Technological Institute of Aeronautics (ITA), São Jose dos Campos, in 1989 and the M.Sc. degree in physics from the Federal University of Pernam-
Brazil, in 1989 and 1992, respectively. He received the Ph.D. in civil and envi- buco, Recife, Brazil, in 1992. He received the Ph.D. degree in applied physics
ronmental engineering from the University of California, Berkeley, in 1999. from the University of Antwerpen, Antwerp, Belgium, in 1998.
He is currently a Senior Researcher with the German Institute for Economics He is currently a Senior Quantitative Analyst with Credit Risk Modeling,
Research (DIW), Berlin, Germany. His research interests include transportation Dexia Bank, Dexia Group, Brussels, Belgium. His research interests include
and energy economics and finance. finance, operations, and economics.