Abstract
Purpose The purpose of this paper is to examine the impact of structural breaks on the conditional variance of carbon emission allowance prices. Design/methodology/approach The authors employ the symmetric GARCH model, and two asymmetric models, namely the exponential GARCH and the threshold GARCH. Findings The authors show that the forecast performance of GARCH models improves after accounting for potential structural changes. Importantly, we observe a significant drop in the volatility persistence of emission prices. In addition, the effects of positive and negative shocks on carbon market volatility increase when breaks are taken into account. Overall, the findings reveal that when structural breaks are ignored in the emission price risk, the volatility persistence is overestimated and the news impact is underestimated. Originality/value The authors are the first to examine how the conditional variance of carbon emission allowance prices reacts to structural breaks.
Highlights
Structural breaks in volatility are found to characterize the volatility dynamics of many conventional assets such as equities (Stărică and Granger, 2005), commodities (Ewing and Malik, 2017) and currencies
The estimates from the extended GARCH model indicate a significant drop in volatility persistence (i.e. α + β)
Employing a set of GARCH-class models, we show that the forecast performance of GARCH models improves when accounting for the presence of structural breaks and that the volatility persistence of European Union Allowance (EUA) prices decreases
Summary
Structural breaks in volatility (i.e. volatility shifts) are found to characterize the volatility dynamics of many conventional assets such as equities (Stărică and Granger, 2005), commodities (Ewing and Malik, 2017) and currencies. If they are not properly taken into account, they can lead to over-persistent GARCH models (Hillebrand, 2005), affecting volatility forecasts (Stărică and Granger, 2005). While the effect of structural breaks on the modeling and forecasting of the volatility of many assets has been empirically examined, there is very limited evidence of that effect in the carbon emission market.
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