International Review of Economics and Finance 14 (2005) 41 – 55

www.elsevier.com/locate/econbase

Extreme value theory and extremely large electricity

price changes
Hans N.E. Byström *,1
Department of Economics, Lund University, P.O. Box 7082, S-220 07 Lund, Sweden

Received 24 October 2001; received in revised form 22 June 2002; accepted 17 December 2002
Available online 3 May 2003

Abstract

Nord Pool, the first multinational exchange for electricity trading, has existed since January 1996. Typical
characteristics of electricity prices on Nord Pool are a very high volatility and a large number of very large, or
extreme, price changes. In this paper, we look at hourly spot prices on Nord Pool and apply extreme value theory
(EVT) to investigate the tails of the price change distribution. We get a good fit of the generalized Pareto distribution
(GPD) to AR – GARCH filtered price change series, and accurate estimates as well as forecasts of extreme quantiles
are produced. Generally, our results suggest EVT to be of interest to both risk managers and portfolio managers in the
highly volatile electricity market.
D 2003 Elsevier Inc. All rights reserved.

JEL classification: C22; C53; G19; Q49

Keywords: Electricity prices; Conditional extreme value theory; GARCH; Tail quantiles

1. Introduction

In this paper, we deal with electricity price changes on the Nordic Power Exchange, ‘‘Nord Pool.’’
Due to the general problem of storing electricity, the price changes in this market are often very large and
to quantify the sizes and probabilities of these (extreme) price changes, we turn to the field of extreme
value theory (EVT). This approach is supposed to capture the extreme price behavior better than
traditional time-series models.

* Tel.: +61-2-9514-7732; fax: +61-2-9514-7711.

E-mail address: hans.bystrom@nek.lu.se (H.N.E. Byström).
1
Present address: School of Finance and Economics, University of Technology, Sydney, P.O. Box 123, Broadway NSW
2007, Australia.

1059-0560/$ - see front matter D 2003 Elsevier Inc. All rights reserved.
doi:10.1016/S1059-0560(03)00032-7
42 H.N.E. Byström / International Review of Economics and Finance 14 (2005) 41–55

The modeling of extreme events is the central issue in EVT and the main purpose of the theory is to
provide asymptotic models with which we can model the tails of a distribution. EVT has been around for
some time, from the pioneering work of Fisher and Tippett (1928), followed by Gnedenko’s (1943)
famous extreme value theorem to the exposé by Gumbel (1958). More recently, Balkema and de Haan
(1974) and Pickands (1975) have presented the basic foundation for threshold-based extreme value
methods.
Applications of the theory have since appeared in different areas, for instance, in hydrology and wind
engineering, and lately, we have seen an increased interest in EVT applied to finance and insurance.
Presentations emphasizing these applications can be found in Embrechts, Kluppelberg, and Mikosh
(1997) and Reiss and Thomas (1997).
One market that is currently developing rapidly and that in many ways behaves as (or in some
cases actually is) a financial market is the market for electricity. Electricity has traditionally been
bought and sold over-the-counter, however, over the last 5 to 10 years, organized exchanges for
electricity have appeared. All over the world, there are only a handful of electricity exchanges, with
the Nordic power exchange, Nord Pool, being the only multinational one. On Nord Pool, electricity
can be bought and sold both ‘‘on the spot,’’ and in advance using financial futures and forward
contracts with the spot electricity as the underlying ‘‘asset.’’2,3 The main reason for trading in futures
and forwards is for actors to monitor the volatility of their power portfolios and to minimize the
negative effect of adverse fluctuations in electricity prices; something that is particularly important in
the electricity market where we have both an exceptionally high price volatility and a large number of
extreme prices.4
In this paper, we focus on the distribution of intradaily electricity price changes and calculate
associated extreme quantiles by fitting both traditional time-series models and an EVT-based model to
observed price data. We have chosen to focus only on the positive tail of the distribution. This is done in
order to save space, and does not mean that we consider the positive tail more important than the
negative tail. While some participants in the electricity market (e.g., large industrial electricity
consumers) are more concerned about unexpected price increases, others (e.g., electricity producers)
are probably more interested in monitoring large price drops than large price increases. The treatment of
the negative tail is otherwise completely analogous to the treatment of the positive tail, only the scale of
the most extreme price movements is different.5
With the extreme behavior (the high volatility and the large number of extreme price changes) seen in
the electricity market and an increased interest in risk management of electricity positions, there is a
growing need for stress results and the assessment of worst-case scenarios in the electricity market. EVT
could be used as a complement to such stress tests to see whether extreme price situations, such as the

2
Different kinds of options contracts on electricity (European futures options, Asian options) are also available.
3
In this paper, we only look at spot prices. There are many reasons to believe that the results in this paper spill over to the
futures, forward, and options markets, however. Possible uses of EVT could then be to calculate margin requirements in the
futures market or to price different kinds of electricity options.
4
Electricity cannot, in principle, be stored. It has to be consumed the very second it is produced, and in this way, it is more
like a service than a good. This creates not only a very volatile behavior of the electricity price but also a strong seasonality
pattern. It also complicates the pricing of electricity derivatives.
5
A negative price change cannot exceed 100%.
 H.N.E. Byström / International Review of Economics and Finance 14 (2005) 41–55 43

recent California electricity crisis, are truly extreme low-probability events or situations that will appear
on a regular basis. The extreme electricity price movements can be investigated using EVT in either an
unconditional framework (Byström, 2000), where no consideration is given to dependencies or
seasonalities in the time-series data, or in a conditional framework where dependencies are modeled
explicitly. The latter approach is the preferred one if one wants to apply the extreme value methodology
to short-term (day-by-day) risk management and in this paper we extend the classic unconditional
extreme value approach by first filtering the data to capture some of the dependencies in the electricity
market, and thereafter applying ordinary extreme value techniques (McNeil and Frey, 2000). In this way,
we not only get better tail estimates in-sample, but more importantly, it also gives us better predictions of
future extreme price changes. An additional advantage is that the IID assumption behind the EVT-based
tail-quantile estimator is less likely to be violated.
The paper is organized as follows: Section 2 gives a brief introduction to the Nordic power exchange
and describes the data and the statistical particularities of intradaily electricity prices in this market,
Section 3 describes our tail-quantile estimators, with special emphasis on EVT, and Section 4 presents
the results from an application of the conditional extreme value method to quantile estimation as well as
multiperiod forecasting in the electricity market. Section 5 concludes the paper.

2. Electricity prices on Nord Pool

In January 1996, the Swedish electricity market was deregulated and integrated with the previously
deregulated Norwegian electricity market. At the same time, the first multinational power exchange,
Nord Pool, was created in Scandinavia. This exchange has participants from Norway, Sweden, Denmark,
Finland, Germany, The Netherlands, England, and the United States, but only the Norwegian and the
Swedish markets are fully integrated. Of all trade in electric power in these two countries, around 25%
(January 1998) is managed by Nord Pool; the main part of the electricity trade is still being organized as
bilateral contracts between producers and consumers.

2.1. The spot market

In this paper, we deal with Nord Pool’s market for spot electricity. The spot market is a market for
physical delivery of electricity and despite being called the ‘‘spot’’ market, in reality, it is a short-term (1-
day) futures market; each day at noon, spot prices and volumes for each hour the following day are
determined at an auction. Since the purpose of this paper is only to describe the distribution of price
changes, we treat the electricity prices as if they were true spot prices all through the paper.
In addition to being an indicator of the current price for electricity, the spot prices is also an important
underlying parameter for the pricing and trading in derivatives. Forwards, futures, and options on
electricity are traded on Nord Pool, and when spot electricity is used as an underlying asset for these
derivatives, the spot price is usually aggregated over time; daily, weekly, or monthly prices are calculated
from the hourly prices. These aggregated prices, as well as the hourly prices used in this study, show a
great deal of seasonality. This seasonality is due to the problem of electricity storage, and for the hourly
prices, the seasonality pattern is directly related to changing demands of electricity over the 24 hours of
the day as well as the 7 days of the week; the demand is higher during the day than during the night, and it
is also higher during the week than at weekends. For aggregated prices, it is the change in temperature
44 H.N.E. Byström / International Review of Economics and Finance 14 (2005) 41–55

Fig. 1. Electricity price (Nkr/MW h), January 1, 1996 to October 1, 2000.

from summer to winter, with an associated change in electricity demand, that leads to high prices during
the winter and low during the summer.6
Compared to typical financial assets like stocks and bonds, the size of the price changes on Nord Pool is
extreme to say the least. Hourly prices over the last 5 years are plotted in Fig. 1, and over the 5-year history
of the exchange electricity prices have some hours go as high as 1800 Nkr/MW h and some hours go as low
as 18 Nkr/MW h. Even if the long-term swings in prices are large, the short-term movements are even more
extreme; hourly price changes of 100% are commonplace (from 7:00 a.m. to 8:00 a.m., January 24, 2000,
the price changed from 141 Nkr/MW h to 993 Nkr/MW h, a 606% change!). Since the price changes are so
large, we have chosen to use simple net returns ( Pt
Pt
1)/Pt
1 instead of logarithmic returns; the simple
net return from a typical price change from 100 to 150 is 50%, while the logarithmic return calculated from
the same price change is 40.55%. A problem with using simple returns is that prices are bounded from
below and, that is, makes the return distribution skewed for large positive and negative returns; if one is
interested in large price drops, one has to acknowledge the lower bound of
100%. For instance, a price
decline from 100 to 20 is only a drop of 80%, while a price jump from 20 to 100 is an increase of 400%.
Since we only look at extreme returns in the positive tail (large price increases), this is of no major concern
to us.

2.2. Data

The data we use are hourly spot prices from Nord Pool for almost 5 years, January 1, 1996 to October
1, 2000.7 In total, we have 41,665 hourly prices and from these prices [quoted Norwegian kroner (NOK/

6
The Nordic countries are fairly cold during the winter and therefore more heating (which usually comes from electricity) is
needed during the winter. This leads to a general price increase during the winter months. In other parts of the world, the
situation might be reversed; the increased use of air-conditioning during the summer months gives higher prices during the
summer.
7
The data were kindly provided by Nord Pool.
 H.N.E. Byström / International Review of Economics and Finance 14 (2005) 41–55 45

Table 1
Descriptive statistics, hourly price changes (simple net returns), January 1, 1996 to October 1, 2000
Mean (%) Standard deviation (%) Skewness Kurtosis Q(6) Q(24) Q2(6) Q2(24)
0.179 6.94 20.8 1495 9359 29,473 1137 7073
Kurtosis is the excess kurtosis. Q(6) and Q(24) are the Ljung – Box tests for autocorrelation at lags 6 and 24 (in the return series
and the squared return series). 99% critical values for the Ljung – Box tests are 16.8 and 43.0.

MW h)] we calculate 41,664 hourly simple net returns.8 Among all these 41,665 prices only the prices of
those hours when the change to and from daylight saving time occurs have been modified. These
changes concern the price between 2:00 a.m. and 3:00 a.m. the last Sunday of March and of October
each year; in March the price of the disappearing hour is defined (by the author) by an interpolation
between the previous and the following price and in October the average of the two prices between 2:00
and 3:00 is used. In this way, each day in the data set we get 24 h.
Table 1 reports some statistics on the price change series, and the features discussed above concerning
the nonnormality of the price change distribution [in addition to that due simply to the lower bound
(
100%) of simple net returns] and the very high volatility are confirmed; the unconditional distribution
of the simple net returns is obviously nonnormal, as evidenced by very high skewness and excess kurtosis,
at the same time as the high variance is evidence of a very volatile electricity price. Fifteen returns are larger
than 100% (more than a doubling of the price from one hour to the next) and the Top 3 returns are 606%,
248%, and 168%, respectively. More than 400 returns are larger than 20% and a 10th of the sample is larger
than 4%.
In Table 1 we also present very high Ljung–Box statistics indicating strong autocorrelation in the return
series.9 The very high value of Q(24) is obviously due to the earlier mentioned 24-h seasonality. Ljung–
Box statistics on the squared returns [ Q2(6) and Q2(24)] are also highly significant and this together with a
visual inspection of Fig. 2 indicates a high degree of volatility clustering (GARCH effects).

3. EVT and the modeling of electricity price changes

As one of the most well-known methods of EVT, the peaks-over-threshold (POT) method deals with
those events in a certain data set that exceed a high threshold and model these separately from the rest of
the observations.10 In this paper, we extend the standard POT approach by prefiltering with an ordinary
time-series model, taking into consideration autocorrelation in the returns themselves (AR), as well as in
the squared returns (GARCH). We then follow McNeil and Frey (2000) by applying the extreme value
machinery to the residuals.

8
The 366 + 365 + 365 + 365 + 275 = 1736 days makes 1736  24 = 41,664 hourly returns.
9
The Ljung – Box test statistic is used to test the null hypothesis of no autocorrelation in a time series at a certain lag. A
Ljung – Box test statistic above 16.8 [ Q(6)] or 43.0 [ Q(24)] indicates significant autocorrelation in the series up until the
specified lag. Applied to squared returns, the Ljung – Box test is often used as a test of possible GARCH effects in the time
series.
10
In the following we look only at the upper tail (maxima) of the distribution. The lower tail (minima) can be treated in an
analog way.
46 H.N.E. Byström / International Review of Economics and Finance 14 (2005) 41–55

Fig. 2. Electricity price changes (%), January 1, 1996 to October 1, 2000.

3.1. Modeling time dependencies

In order to prefilter the series, there are many time-series models that could be used, and our choice of
a combined AR and GARCH model is due to the strong seasonality pattern and the significant volatility
clustering in the electricity market. The seasonality in the spot market is particularly obvious over the
day (24 h) and over the week (168 h). We therefore include AR(24) and AR(168) terms in the model in
addition to an AR(1) term. By combining this AR model with the simplest possible GARCH model
(GARCH(1,1)), that explicitly models the conditional volatility as a function of past conditional
volatilities and returns (Bollerslev, 1986; Engle, 1982), we hope to capture the most important
dependencies in the return series.
All through the paper our AR–GARCH model looks as follows:

rt ¼ a0 þ a1 rt
1 þ a2 rt
24 þ a3 rt
168 þ et

r2t ¼ /0 þ /1 e2t
1 þ /2 r2t
1 ð1Þ

where r2t is the conditional variance of et. et is equal to rtgt with gt f N(0, 1) or f Student’s t-distributed
IID innovations (scaled to have variance one) with mean = 0, variance = 1 and degree of freedom
parameter, t. The reason for including the t-distribution is, of course, that empirical evidence strongly
rejects the idea that electricity price changes are normally distributed (Byström, 2000). Considering the
extreme price changes in the electricity market, one is also quite likely to end up with /-parameters
whose sum is larger than 1 (an infinite unconditional variance cannot be rejected). This creates some
problems when interpreting r2t as a conditional variance.
When the AR–GARCH model in Eq. (1) has been fitted to data by maximizing the likelihood
function, one can estimate (and forecast) conditional tail quantiles, at,p, by assuming either the normal
distribution or the t-distribution, multiplying ones estimates of rt with the standard quantiles of each
distribution, and finally, adding the conditional mean. In this way, we acknowledge the time depend-
 H.N.E. Byström / International Review of Economics and Finance 14 (2005) 41–55 47

encies in our series, but compared to the EVT-based approach described below, the AR–GARCH
models with normal or t-distributed error terms do not focus directly on the returns in the tails.
In order to introduce the extreme value machinery to the estimation of (extreme) tail quantiles, the
first step is to model the residuals, gt, from the normal AR–GARCH model with the POT model
(described below). Since the residual series is much closer to being IID than the original series, it is
straightforward to apply EVT.11 If we call the unconditional EVT quantiles of the residual distribution
ap, we can, as a second step, easily calculate the conditional tail quantiles, at,p, of our original return
distribution as
at;p ¼ a0 þ a1 rt
1 þ a2 rt
24 þ a3 rt
168 þ rt ap ð2Þ
where a0 + a1rt
1 + a2rt
24 + a3rt
168 and rt is the conditional mean and volatility from our AR–
GARCH model. What we do is essentially to scale our extreme tail estimates from the residual series with
the mean return and volatility. In this way, we get conditional estimates of extreme tail quantiles. If we
instead want (one-period) forecasts of the conditional quantiles, we simply produce one-step-ahead
forecasts of the conditional mean and volatility in Eq. (1) and use these values to scale up our residual
quantiles with Eq. (2).
We have now showed how one can combine ordinary time-series modeling with EVT to produce tail-
quantile estimates. In the next subsection we briefly introduce the POT method that will be used to
model the residuals, gt, in Eq. (1).

3.2. The POT method

The main idea behind the POT method is to collect the observations in the (residual) series that exceed
a certain high threshold, u, and model these observations separate from the rest of the distribution. A
more detailed discussion of the generalized Pareto distribution (GPD) and the POT method can be found
in McNeil and Frey (2000) as well as in Embrechts et al. (1997) and here we only give a brief
presentation of the method.
We start by calling a daily observation in our data series R and assume that it comes from a
distribution FR. The observations above the threshold u then follow the excess distribution Fu( y) that is
given by
FR ðu þ yÞ
FR ðuÞ
Fu ðyÞ ¼ PðR
uVyR > uÞ ¼ ; 0VyVRF
u ð3Þ
1
FR ðuÞ
where y is the excesses over u, and RF is the right endpoint of FR. If the threshold, u, is high enough,
Balkema and de Haan (1974) and Pickands (1975) show that for a large class of distributions FR the
excess distribution, Fu( y), can be approximated by the so-called GPD
n
Gn;a ðyÞ ¼ ½1
ð1 þ yÞ
1=n ; if np0; ð4Þ
a
Gn;a ðyÞ ¼ 1
e
y=a ; if n ¼ 0:
11
The EVT approach in this paper assumes IID return series. In practical applications, one might expect electricity investors
to deal primarily with portfolios of spot and futures instruments, so-called power portfolios. In that case, the problem with non-
IID residuals might be even less important.
48 H.N.E. Byström / International Review of Economics and Finance 14 (2005) 41–55

for 0 V y V RF
u. n is the tail index and a>0 is just a scaling parameter. For the fat-tailed distribution in
this paper, as well as for financial return distributions in general, one can expect a positive n.
The tail index, n, as well as the scaling parameter, a, have to be determined by fitting the GPD to the
actual data and we estimate the parameters with the maximum likelihood method.12
When the GPD distribution and its parameters are estimated, we continue by calculating tail quantiles,
ap, of the underlying distribution FR which can be written as

FR ðu þ yÞ ¼ ð1
FR ðuÞÞFu ðyÞ þ FR ðuÞ: ð5Þ

Acknowledging that FR(u) can be written as (n
Nu)/n where n is the total number of observations and
Nu is the number of observations above the threshold u, and that Fu( y) can be replaced by Gn,a( y) (as
well as rewriting u + y as x), this expression can be simplified to

Nu n 1
FR ðxÞ ¼ 1
ð1 þ ðx
uÞÞ
n : ð6Þ
n a

By inverting this expression, we get an expression for (unconditional) tail quantiles associated with
certain probabilities p,

 
a n
n
ap ¼ u þ ð pÞ
1 : ð7Þ
n Nu

4. Tail-quantile estimates and forecasts

Compared to ordinary financial markets the electricity market is by all means extreme, and in this
section we therefore use EVT to calculate tail quantiles associated with our electricity return series. Both
ordinary 95% and 99% tail quantiles as well as more extreme (99.5–99.99%) tail quantiles are estimated
and evaluated. In addition to in-sample evaluation of the models, we also do an out-of-sample evaluation
of forecasted multiperiod tail quantiles.

4.1. Tail-quantile estimation

For the two AR–GARCH models with normally distributed and with t-distributed errors, maximum
likelihood estimates (using the BHHH algorithm) as well as some statistics on the standardized residuals
are presented in Table 2. For both models, we get significant parameter estimates and /-parameters that
are positive. The sum of the /-parameters is not significantly lower than 1, however, and an infinite
unconditional variance cannot be rejected for any of the two models. This is not surprising considering
the extremely fat-tailed data in our study and it is further supported by the large positive tail-index

12
The likelihood function can be found in, for instance, Embrechts et al. (1997).
 H.N.E. Byström / International Review of Economics and Finance 14 (2005) 41–55 49

Table 2
AR – GARCH parameters, statistics on the standardized residuals, as well as GPD parameters
Normal Student’s t
AR – GARCH parameters
a0  104 1.48 (0.91)
2.32 (1.08)
a1 0.179 (0.00180) 0.150 (0.00276)
a2 0.423 (0.00124) 0.456 (0.00240)
a3 0.250 (0.000238) 0.237 (0.00208)
/0  106 8.97 (3.34) 18.21 (5.06)
/1 0.119 (0.000277) 0.211 (0.00526)
/2 0.883 (0.000276) 0.788 (0.00345)
t 3.001 (0.412)

Standardized residuals statistics

Mean (%) 0.242 1.351
Standard deviation (%) 1.421 1.319
Skewness 29.36 16.32
Excess kurtosis 3875 1741
Q(6) 114.9 207.0
Q(24) 306.1 512.9
Q2(6) 8.8 7.3
Q2(24) 102.3 506.8

GPD parameters
n 0.297 (0.0208)
a 0.812 (0.0224)
u 0.055
Figures in parentheses are standard errors.

estimate for the residual series and, particularly, for the raw return series.13 Finally, the Ljung–Box tests
indicate remaining autocorrelation while most of the heteroscedasticity has been removed.14
Conditional tail quantiles are then easily estimated by multiplying the GARCH volatilities with
quantiles from the standard normal and t-distribution and adding the conditional mean return.15 By
comparing these tail quantiles with the actual returns over the whole sample, and counting the number of
returns that are larger than the estimated tail quantile, we get a number that represents the accuracy of
these estimates. For instance, the theoretical number of exceedences of a 99% tail quantile over a time
period of 41,664 h is 417 (0.01*41,664 = 416.64).
In Table 3, we present the number of exceedences of the AR–GARCH-based tail quantiles for
different tail probabilities. If a particular method to calculate marginal quantiles works well, then the
empirically observed number of exceedences should be close to the theoretically expected. Looking at
the columns associated with the two AR–GARCH models, it is clear that the shape of the conditional

13
n = 0.44 when we fit the GPD directly to the return series.
14
One should remember, however, that we are dealing with high-frequency data and that we actually have removed around
90% of the autocorrelation in the raw returns.
15
This is directly comparable to VaR calculations in ordinary financial investment situations, except that here we talk about
the probability of a large price increase and not about any specific (portfolio) value that is at risk.
50 H.N.E. Byström / International Review of Economics and Finance 14 (2005) 41–55

Table 3
In-sample evaluation of estimated tail quantiles at different probabilities (number of exceedences)
Probability Expected AR – GARCH AR – GARCH – t Conditional GPD
.95 2083 1683 986 2059
.99 417 870 220 437
.995 208 727 93 209
.999 42 484 16 28
.9995 21 427 9 13
.9999 4 327 2 6
The numbers are empirically observed no. of tail-quantile exceedences. They should be as close as possible to the theoretically
expected no. in the second column.

error term distribution has an important impact on the tail-quantile estimates, and that neither the
conditional normal distribution nor the conditional t-distribution captures the behavior of the (positive)
tail very well. While the thin-tailed normal AR–GARCH model seriously underestimates all tail
quantiles (with the exception of the 95% tail quantile), the fat-tailed AR–GARCH–t model system-
atically overestimates all tail quantiles. The performance of the normal model gets worse the further out
in the extreme tail we go, while for the t-distributed model we observe the opposite behavior.
AR–GARCH models are designed to model the behavior of the entire distribution of returns, not only
the most extreme returns, and from the numbers in Table 3 it is obvious that these traditional time-series
models are not very successful in capturing the most extreme movements in our electricity return series.
For the fat-tailed electricity distribution in this study, neither of the two proposed conditional distributions
seems able to model the positive tail accurately. In addition, the earlier mentioned lower boundary of the
price changes creates additional skewness in the tails of the empirical distribution. This obviously makes
the symmetric normal and t-distributions even less suitable for tail-quantile estimations.16
The unconditional EVT-based risk estimator, on the other hand, has the advantage of treating the tails
separately as well as more efficiently. However, compared to unconditional EVT, AR–GARCH models
have the advantage of giving us time varying tail quantiles; when we enter periods with high (low)
volatility, the quantiles are also increasing (decreasing). We therefore combine the two approaches by
applying the unconditional POT method to the residuals from the normal AR–GARCH model.
In implementing the POT method, one fits the GPD to observations in the residual series above a certain
high threshold. One relies on a reasonable choice of threshold, however; too low threshold value and the
asymptotic theory breaks down, too high threshold value and one does not have enough data points to
estimate the parameters in the excess distribution. In order to use observations in the extreme tail only, but
still follow the recommendations from the simulation study in McNeil and Frey (2000), we have chosen to
fix the number of excesses, Nu, to 3000. In this way, we get a threshold u that is approximately 5.5%. Next,
the tail index, n, as well as the scaling parameter a, has to be determined by fitting the GPD to the actual
data. We estimate the parameters with the maximum likelihood method, and n, the tail parameter, is
estimated to be 0.30. We continue by inserting our parameter estimates in Eq. (7) and calculate
unconditional estimates,ap, for the residual distribution. Finally, conditional tail quantiles of our original
return series are calculated with Eq. (2). The results are presented in Table 3.

16
The major reason for the weak performance of the normal and the t-distribution is clearly the explicit misspecification of
the tails, however. The additional skewness due to the lower boundary, on the other hand, is much less important as a replication
of the study in this paper (not presented) to log-returns instead of simple net returns shows.
 H.N.E. Byström / International Review of Economics and Finance 14 (2005) 41–55 51

Table 4
In-sample evaluation of estimated 99% tail quantiles divided by month, with seasonal dummy (within parenthesis) and without
seasonal dummy
Month Expected AR – GARCH AR – GARCH – t Conditional GPD
January 35 62 (104) 13 (26) 29 (42)
February 35 52 (94) 17 (19) 29 (37)
March 35 48 (59) 13 (9) 29 (28)
April 35 76 (71) 23 (17) 51 (38)
May 35 104 (91) 21 (17) 59 (39)
June 35 100 (86) 23 (21) 58 (40)
July 35 126 (100) 26 (35) 65 (46)
August 35 105 (89) 27 (17) 60 (37)
September 35 105 (89) 19 (19) 55 (34)
October 35 90 (86) 13 (19) 47 (29)
November 35 42 (59) 12 (11) 23 (24)
December 35 49 (84) 14 (17) 29 (39)
The numbers are empirically observed no. of tail-quantile exceedences. They should be as close as possible to the theoretically
expected no. (35) in the second column.

In Table 3, we examine the number of exceedences that we have in our sample at different quantiles.
Compared to the earlier results where we assumed either the normal distribution or the t-distribution, the
explicit modeling of the tail obviously pays off with a much better correspondence with empirical
quantiles. Overall, the POT method produces more accurate tail estimates that are close to the empirical
ones both at traditional levels (95% and 99%) and at more extreme levels.17,18
Irrespective of model, the numbers of the empirical and the estimated quantiles obviously differ to
some extent. However, one must remember that it is a very difficult task to estimate as high quantiles as
we are trying to. For example, out of these 41,664 returns we expect 21 returns to exceed the 99.95%
quantile and only 4 to exceed the 99.99% quantile. In the light of this, the observed numbers, at least for
the EVT-based model, are not bad.

4.2. Seasonal effects

Considering the seasonal behavior of the electricity price, one might suspect that the model
performance could depend on, for instance, the time of the year. In order to investigate this we evaluate
the models month by month and present the results (for the 99% measure) in Table 4 (the numbers that
are not within parenthesis). The reasons behind the choice of the 99% tail quantile and not one of the
more extreme tail quantiles is, first, that the 99% measure is much more widely used, and second, that
the expected number of exceedences otherwise would be too small for an accurate statistical assessment.
In Table 4 it is obvious how, irrespective of model, a larger number of exceedences is associated with the
summer months than with the winter months. The relative performance of the different models remains

17
In this paper, we have focused only on the positive tail. However, when fitting the different models to the negative tail we
got exactly the same results; underestimations by AR – GARCH, overestimations by AR – GARCH – t, and a superior
performance of the EVT-based model.
18
In addition to the POT method, we have also calculated tail-quantile estimates using the block maxima method. These
estimates are overall similar to those of the POT method and the results can be received from the author upon request.
52 H.N.E. Byström / International Review of Economics and Finance 14 (2005) 41–55

more or less unchanged compared to the earlier results, regardless of month, and the only conclusion we
can draw is that more exceedences occur during the summer than during the winter.
Obviously, none of our models captures all the dynamics of the electricity price changes. At the same
time, as we can see in Fig. 2, it is obvious that the volatility of the returns varies over time and
systematically is higher during the warmer half of the year and lower during the colder half of the year.19
The volatility changes over the year in a wavelike fashion and, after reaching a lowest level sometime
during the winter, it slowly increases up to a maximum level during the summer.20 The same pattern is
found in Table 4 and a natural way of modeling this wavelike variation is to add a sinusoidal (dummy)
term to the constant term in the volatility equation (Eq. (1)):

2p p
r2t ¼ /0 þ /dummy sinð t
Þ þ /1 e2t
1 þ /2 r2t
1 ð8Þ
8760 2

This additional explanatory term describes the long-run volatility seasonality over the year more
realistically than a traditional (zero–one) dummy.
After including the sinusoidal term in the volatility estimation ð/̂dummy ¼ 16:36 10
6 and signifi-
cant), we reproduce the results from the monthly evaluation in Table 4 (within parentheses). Almost all
the seasonal variation of the performance is now removed and the number of exceedences is generally
more accurate then before. Particularly, the number of exceedences for the EVT-based tail quantiles is
now fairly close to the expected number irrespective of the time of the year. The improvement of the
performance for the 99% quantile is expected to remain for the other quantiles as well, even though the
most extreme quantiles probably are less related to the level of volatility than the lower quantiles (see
Fig. 2).
In practical situations, one would of course apply more elaborate time-series models to the electricity
prices than we have done in this paper. One would also probably be more interested in forecasting tail
quantiles than in pure in-sample estimation of quantiles. It is also possible that multiperiod forecasts
(daily, weekly, monthly) are more interesting than simple one-hour forecasts. Therefore, our next step is
to look at forecasting and how well the different approaches forecast multiperiod (24-h) tail quantiles.

4.3. Tail-quantile forecasting

In order to evaluate the different approaches to calculate tail quantiles in a more realistic way, we turn
to the models’ out-of-sample performance. To do so, we have chosen to divide the sample into an
estimation period and an out-of-sample test period. As estimation period we use the first 2 years of data
(104 weeks or 17,472 h) and each day in the following test period (to reduce the amount of computation
we only make a forecast once a day, at noon) we roll the estimation period one day (24 h) forward. In
other words, we re-estimate the models each day. For the POT method, this means that we use the 1500
largest price changes in the estimation period (following McNeil & Frey, 2000 in their recommenda-

19
It is not clear what causes this pattern but a possible explanation could be that household demand for electricity
smoothens the volatile industrial demand during the colder winter months.
20
There are, of course, deviations from this pattern, and particularly, the most extreme returns seem to come in a more
random fashion.
 H.N.E. Byström / International Review of Economics and Finance 14 (2005) 41–55 53

Table 5
Out-of-sample evaluation of forecasted 24-h tail quantiles at different probabilities (number of exceedences)
Probability Expected AR – GARCH AR – GARCH – t Conditional GPD
.95 50 55 22 58
.99 10 29 5 9
.995 5 25 3 4
The numbers are empirically observed no. of tail-quantile exceedences. They should be as close as possible to the theoretically
expected no. in the second column.

tions). In total, the test period consists of 1000 days (around 3 years). To further increase the realism, we
have chosen to look at 24-h forecasts instead of simple 1-h forecasts. At noon each day in the test period
we forecast tail quantiles for the price change over the following 24 h.21
Multiperiod forecasts of tail quantiles can be produced in several ways. In the case of IID normally
distributed return series, one can rely on square root scaling of single-period forecasts. When the
distribution is nonnormal, or when the returns show dependencies, there are no theoretical arguments for
choosing this scaling rule, however. Despite this, the square root rule is widely used in practical
situations (it is, for instance, the suggested approach in the back testing procedure by the Bank of
International Settlements [BIS]) and in this paper we simply follow the BIS by using square root scaling
of 1-h forecasts to get 24-h forecasts for all models. One should keep in mind, however, that when the
conditional returns come from fat-tailed distributions, this is a simplification, and in order to improve the
accuracy of the forecasts, in these cases, one could turn to the simulation approach in McNeil and Frey
(2000).22 The a-scaling rule suggested by Danı́elsson (2000), where the square root is replaced by the
‘‘tail-index root’’ (raise the number of periods to the power of the estimated tail index), has also been
applied but with worse performance than the simple square root rule. It was therefore not used in this
paper.
In order to capture the dependency of the hourly returns, we re-estimate the AR–GARCH model in
the previous subsection each day (including the volatility dummy) and in a standard iterative fashion we
create daily forecasts (built up of forecasts at different horizons between 1 and 24 h) of the conditional
mean and volatility that can be used to scale up the residual (square root scaled) 24-h tail quantiles.
The results from the out-of-sample evaluation are displayed in Table 5. The fairly short test period
(1000 days) makes it impossible to evaluate (with statistical significance) more extreme tail-quantile
forecasts than the 99.5% quantile, but the general picture from the in-sample study very much remains;
again it is only the EVT-based quantiles that are reasonably close to the expected ones both at the 95%
level and at more conservative levels further out in the tail. When it comes to the normal distribution and
the t-distribution, the results are again very similar to those in the in-sample study; while the normal
model generally underestimates the risk, the t-distribution overestimates tail quantiles, particularly at low
quantiles.

21
We assume the forecast is made right before the daily settlement of tomorrow’s prices at 12 a.m. In this way, only the first
12 future hourly prices are known when the forecast is made. In order to increase the realism even further, one could for
instance choose to forecast the 24-h price change from the following midnight to the next. For simplicity, however, we choose
the more straightforward lunch to lunch price change forecast.
22
The size of our data set would make this approach very time consuming, however.
54 H.N.E. Byström / International Review of Economics and Finance 14 (2005) 41–55

The results from this study of multiperiod forecasting indicate an improvement to risk management in
the electricity market from using fairly simple techniques stemming from EVT; the number of
exceedences in the POT case is overall very close to the expected ones, and the numbers in Table 5
generally indicate a better modeling of the tails using EVT.

5. Conclusions

In this paper, we have investigated electricity prices quoted on Nord Pool. The price changes in this
market are not only very volatile but their empirical distribution is also highly nonnormal with a large
number of extremely large observations. In addition, the difficulties with storing electricity introduce
sesonalities in the price series that spill over to the return series. In order to model extreme price changes
and to estimate and forecast tail quantiles, we filter the return series with an AR–GARCH model and
then apply results from EVT to the residuals. We find the POT method to model the extreme tails of
hourly electricity price changes with high accuracy. Estimates of both moderate and more extreme tail
quantiles are found to be more accurate than those from ordinary AR–GARCH models with normally or
t-distributed errors.
Further, by explicitly modeling the time-of-the-year seasonality of the volatility, we improve the
overall performance of the models when it comes to estimating accurate tail quantiles. Finally, out-of-
sample evaluation of multiperiod tail-quantile forecasts strengthens the already strong in-sample support
for (conditional) EVT-based risk management in the electricity market; accurate power portfolio ‘‘value-
at-risk’’ forecasts at different horizons can easily be produced regardless if you are a electricity trader,
broker, distributor, consumer, or producer. Considering the frequent extreme price changes in the
electricity market, the participants can rely on EVT-based risk management tools when assessing the
risks in their sometimes fairly elaborate power portfolios.
In addition to the construction of accurate value-at-risk measures, one possible application of EVT in
the electricity market could be the setting of appropriate margins in the electricity futures market, while
another could be a power portfolio manager’s assessment of worst-case scenarios in this very turbulent
market.
When it comes to the pricing and hedging of electricity derivatives, it is important to understand that
such contracts often are more complex than in the traditional financial markets. Asian options, for
instance, are very common due to the particular contractual specifications of delivery in this market
(electricity has to be consumed the very second it is produced). The Gaussian assumption of traditional
option pricing models is therefore particularly critical in the electricity market and a better modeling of
the tails could improve pricing of derivatives such as look-back options.
To summarize, the methods described in this paper could be useful at different steps of the risk
management process of risky electricity portfolios as well as in the pricing and hedging of different types
of derivatives in the electricity market, when properly fine-tuned according to the actual application.

Acknowledgements

The author is particularly grateful for helpful comments received from participants at the International
Conference on Financial and Real Markets, Risk Management and Corporate Governance in Port el
 H.N.E. Byström / International Review of Economics and Finance 14 (2005) 41–55 55

Kantaoui, Tunisia and at the IAFE Annual Research Conference on Financial Risk in Budapest,
Hungary. Financial support from Jan Wallanders och Tom Hedelius Stiftelse and Crafoordska Stiftelsen
is also gratefully acknowledged.

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