Volatility modelling of CO2 spot prices

Abstract

In this paper 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. We use daily spot market data from the second trading period of the EU ETS. Emphasis is given to short-term forecasting of prices and volatility. Due to the characteristics of the price process, such as volatility modelling, breaks in the volatility process and heavy-tailed distributions, we investigate the use of Markov switching GARCH (MS-GARCH) models. We find that these models distinguish well between states, and that the volatility processes in the states are clearly different. Our findings 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.