The goodness-of-fit of the fuel-switching price using the mean-reverting Lévy jump process

This article analyzes the interactions between the electricity and CO2 (carbon) markets. In particular, we describe the dynamics of the fuel-switching price (from coal to gas) when taking into account carbon costs. Several stochastic processes are considered to model the fuel-switching price: (i) the Brownian motion, and (ii) the Lévy jump process. Besides, the probability density function is evaluated by considering the Gaussian case versus the Normal Inverse Gaussian and the Variance Gamma distributions. The results unambigu- ously point out the need to resort to jump modeling techniques to model satisfactorily the fuel-switching price with evidence of heavy tails. The Gaussianity assumption is also clearly rejected in favor of its main competitors, whereas it is found that the NIG beats the Variance Gamma distribution. Taken together, these empirical results convey implications for risk managers looking to forecast and hedge their utilities’ production.