Contagion in Electricity Markets: Does it Exist?

Abstract

This paper investigates the existence of contagion effects in electricity markets. The concept of contagion has been developed for high frequency financial markets, see the World Bank definition(Word Bank, 2000). Following Pick (2005) and Pesaran - Pick (2007) the paper presents a canonical, econometric model of contagion and investigates the conditions under which contagion can be distinguished from mere interdependence. The theoretical and empirical distinction between contagion and interdependence is based upon precise identification conditions, discussed in the paper. The empirical analysis is based on different regional markets in the Italian Power Exchange (IPX) and we focus only on pure contagion relationship in the IPX at the Italian regional level. This is a novel result in economic literature. The analysis and identification of contagion requires that each individual market equations contains market specific regressors, consequently we have to involve market specific variables in structural equations in order to correctly specify the model. Pesaran - Pick (2007, p. 1266) show that ignoring endogeneity and interdependence can introduce a substantial upward bias in estimation of contagion coefficient. In general, problems of endogeneity requires usage of instrumental variables (IV)estimation and, in agreement with Pick (2005), we obtain consistency by including regional market specific fundamentals. The most important conclusions of this paper are that contagion can be identified separately from interdependence and that effects are asymmetric.