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Volatility modelling of CO2 emission allowance spot prices with regime-switching GARCH models

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  • Benschopa, Thijs
  • López Cabreraa, Brenda

Abstract

We analyse the short-term spot price of European Union Allowances (EUAs), which is of particular importance in the transition of energy markets and for the development of new risk management strategies. Due to the characteristics of the price process, such as volatility persistence, breaks in the volatility process and heavy-tailed distributions, we investigate the use of Markov switching GARCH (MS-GARCH) models on daily spot market data from the second trading period of the EU ETS. Emphasis is given to short-term forecasting of prices and volatility. We find that MS-GARCH models distinguish well between two states and that the volatility processes in the states are clearly different. This finding can be explained by the EU ETS design. Our results support the use of MS-GARCH models for risk management, especially because their forecasting ability is better than other Markov switching or simple GARCH models.

Suggested Citation

  • Benschopa, Thijs & López Cabreraa, Brenda, 2014. "Volatility modelling of CO2 emission allowance spot prices with regime-switching GARCH models," SFB 649 Discussion Papers 2014-050, Humboldt University Berlin, Collaborative Research Center 649: Economic Risk.
    • Handle: RePEc:zbw:sfb649:sfb649dp2014-050
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    References listed on IDEAS

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    2. Segnon, Mawuli & Lux, Thomas & Gupta, Rangan, 2017. "Modeling and forecasting the volatility of carbon dioxide emission allowance prices: A review and comparison of modern volatility models," Renewable and Sustainable Energy Reviews, Elsevier, vol. 69(C), pages 692-704.
    3. Zhao, Xin & Han, Meng & Ding, Lili & Kang, Wanglin, 2018. "Usefulness of economic and energy data at different frequencies for carbon price forecasting in the EU ETS," Applied Energy, Elsevier, vol. 216(C), pages 132-141.
    4. Xu, Jia & Tan, Xiujie & He, Gang & Liu, Yu, 2019. "Disentangling the drivers of carbon prices in China's ETS pilots — An EEMD approach," Technological Forecasting and Social Change, Elsevier, vol. 139(C), pages 1-9.
    5. Hartvig, Áron Dénes & Pap, Áron & Pálos, Péter, 2023. "EU Climate Change News Index: Forecasting EU ETS prices with online news," Finance Research Letters, Elsevier, vol. 54(C).
    6. Cong, Ren & Lo, Alex Y., 2017. "Emission trading and carbon market performance in Shenzhen, China," Applied Energy, Elsevier, vol. 193(C), pages 414-425.
    7. Benschop, Thijs & López Cabrera, Brenda, 2017. "Realized volatility of CO2 futures," SFB 649 Discussion Papers 2017-025, Humboldt University Berlin, Collaborative Research Center 649: Economic Risk.

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    More about this item

    Keywords

    CO2 Emission Allowances; CO2 Emission Trading; Spot Price Modelling; Markov Switching GARCH Models; Volatility Forecasting;
    All these keywords.

    JEL classification:

    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
    • Q49 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Energy - - - Other
    • Q53 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Air Pollution; Water Pollution; Noise; Hazardous Waste; Solid Waste; Recycling
    • Q59 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Environmental Economics - - - Other

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