Modeling and Forecasting the Volatility of carbon Dioxide emission Allowance Prices: A Review and Comparison of Modern Volatility Models

Segnon Mawuli, Lux Thomas, Gupta Rangan

Abstract
The launch of the markets for carbon dioxide emission allowances was guided bythe aim to use the supposedly ecient price formation mechanism of an organized exchange tooptimally allocate a certain quantity of emissions among potential polluters. While this introductionof a centralized trading arrangement should have helped to achieve required emissionreductions with a minimum of economic loss, from the viewpoint of market participants it hasraised concerns about appropriate risk management provisions to cope with the fluctuations oftime-varying allowance prices. The present review provides an overview over state-of-the-artmodels for price volatility expanding the scope from relatively simple GARCH-type models tomodels with long-term dependence and regime switches including the relatively recent class ofso-called multifractal models. We provide a comparative application of these models to carbondioxide emission allowance prices from the European Union Emission Trading Scheme and evaluatetheir performance with up-to-date model comparison tests based on out-of-sample forecastsof future volatility and value-at-risk.

Keywords
Carbon dioxide emission allowance prices; GARCH; Markov-switching GARCH; FIGARCH; Multifractal Processes; SPA test; encompassing test; backtesting