Modelling the EU allowances spot price with regime-switching models

This study investigates the behaviour of the spot price of carbon emission allowance in the European Union Emissions Trading Scheme (EU ETS). The volatility clustering phenomenon is observed for the daily returns of the spot price. Motivated by this phenomenon, we implement the regime-switching mechanism into four stochastic models. The parameters of proposed regime-switching models are governed by a hidden Markov chain, which enables the time-dependent parameterisation and captures the volatility clustering property. The non-switching stochastic models are used as the baseline models to benchmark the regime-switching models in the context of in-sample fitting and out-of-sample forecasting performance. Furthermore, we price European-style future call options with the proposed models. The models are assessed by comparing the pricing errors. Based on the results of the in-sample and out-of-sample analyses, and the option pricing exercise, the proposed regime switching geometric Brownian motion model provides the best fit to the spot price dynamic.