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 longterm
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.
