Modeling the price dynamics of CO2 emission allowances

In this paper we analyze the short-term spot price behavior of carbon dioxide (CO2) emission allowances of the new EU-wide CO2 emissions trading system (EU ETS). After reviewing the stylized facts of this new class of assets we investigate several approaches for modeling the returns of emission allowances. Due to different phases of price and volatility behavior in the returns, we suggest the use of Markov switching and AR-GARCH models for stochastic modeling. We examine the approaches by conducting an in-sample and out-of-sample forecasting analysis and by comparing the results to alternative approaches. Our findings strongly support the adequacy of the models capturing characteristics like skewness, excess kurtosis and in particular different phases of volatility behavior in the returns. Crown Copyright (C) 2008 Published by Elsevier B.V. All rights reserved.