Modeling and Explaining the Dynamics of European Union Allowance Prices at High-Frequency

This paper contributes to a relatively new research area called "carbon finance". In simple terms, carbon finance deals with finance and carbon dioxide permit market related issues. The research focuses, for example, on the stochastic properties of carbon permit prices or their empirical relation to fundamental price drivers. The existing literature deals primarily with EU carbon permits - the so called European Union Allowances (EUAs). Recent results suggest that EUA prices are closely connected to energy prices, in particular to electricity, gas and crude oil prices. In addition, sectoral production or regulatory issues also significantly determine the EUA price. Other results show that macroeconomic risk factors, such as the default spread, the short-term interest rates or selected market portfolios are only loosely related to the EUA price. This paper extends the existing literature on carbon finance by modeling the adjustment process of EUAs prices to scheduled macroeconomic and regulatory announcements. The modeling focuses on high-frequency price dynamics and takes into account the most distinctive features of EUA returns, in particular intraday periodicity, volatility clustering and volatility persistence. The analysis shows that the high-frequency EUA price dynamics are very well captured by a fractionally integrated asymmetric power GARCH process - a process based on fractional integration that is able to capture the slow decay in the autocorrelation function of the squared returns. The decisions of the European Commission on second National Allocation Plans (that are used as a proxy for scheduled regulatory announcements) have a strong and immediate impact on EUA prices. On the other hand, the results suggest that scheduled macroeconomic announcements are only weakly connected to the EUA price. According to these results, the information processing in the EU carbon permit market at high-frequency seems to differ from the price formation in foreign exchange, bond or equity markets, where prices react strongly and immediately to scheduled macroeconomic releases.

Conrad, Christian, Daniel Rittler and Waldemar Rotfuß (2010), Modeling and Explaining the Dynamics of European Union Allowance Prices at High-Frequency, ZEW Discussion Paper No. 10-038, Mannheim.