Humboldt-Universität zu Berlin - High Dimensional Nonstationary Time Series

SFB649DP2014 050

Volatility Modelling of CO2 Emission Allowance Spot Prices with Regime-Switching GARCH Models

Thijs Benschop
Brenda López Cabrera

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.

CO2 Emission Allowances, CO2 Emission Trading, Spot Price Modelling, Markov Switching GARCH Models, Volatility Forecasting

JEL Classification:
C53, G17, Q49, Q53, Q59