Assessing the risk of the European Union carbon allowance market: Structural breaks and forecasting performance

Abstract

Purpose: The purpose of this paper is to examine the impact of structural breaks on the conditional variance of carbon emission allowance prices. Design/methodology/approach: The authors employ the symmetric GARCH model, and two asymmetric models, namely the exponential GARCH and the threshold GARCH. Findings: The authors show that the forecast performance of GARCH models improves after accounting for potential structural changes. Importantly, we observe a significant drop in the volatility persistence of emission prices. In addition, the effects of positive and negative shocks on carbon market volatility increase when breaks are taken into account. Overall, the findings reveal that when structural breaks are ignored in the emission price risk, the volatility persistence is overestimated and the news impact is underestimated. Originality/value: The authors are the first to examine how the conditional variance of carbon emission allowance prices reacts to structural breaks.