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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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    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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