Modeling and forecasting the volatility of carbon dioxide emission allowance prices: A review and comparison of modern volatility models

Abstract

The launch of the markets for carbon dioxide emission allowances was guided by the aim to use the supposedly efficient price formation mechanism of an organized exchange to optimally allocate a certain quantity of emissions among potential polluters. While this introduction of a centralized trading arrangement should have helped to achieve required emission reductions with a minimum of economic losses, from the viewpoint of market participants it has raised concerns about appropriate risk management provisions to cope with the fluctuations of time-varying allowance prices. The present review provides an overview over state-of-the-art models for price volatility expanding the scope from relatively simple GARCH-type models to models with long-term dependence and regime switches including the relatively recent class of so-called multifractal models. We provide a comparative application of these models to carbon dioxide emission allowance prices from the European Union Emission Trading Scheme and evaluate their performance with up-to-date model comparison tests based on out-of-sample forecasts of future volatility and value-at-risk.