Modeling carbon spot and futures price returns with GARCH and Markov switching GARCH models

This paper thoroughly investigates the price dynamics of carbon spot and futures returns for the first commitment period ranging from 2008 to 2012 with the aim to develop an adequate spot-returns-model. We apply a broad spectrum of various GARCH models including different distributions for model innovations. Both time series, spot and futures returns, exhibit asymmetric behavior in their variance, thus, additionally Markov regime switching models for the variance equation of carbon returns are under consideration. Empirical results prove AGARCH, NARCH and GJR to fit the data best, further we show that fat tailed distributions in particular a generalized error distribution in the error term of any model significantly improves the fit. Finally, as futures returns seem to carry informational content concerning subsequent spot returns, we propose a sound, yet parsimonious spot-returnsmodel, well suited for capturing the dynamics of the carbon spot market.