Simulating and Assessing Carbon Markets

This study simulates carbon markets more accurately with a Multi-CDF inversion approach coupled with GARCH volatility model. Without the restriction of a normal distribution assumption, atypical patterns of price return distribution in illiquid and immature markets are modeled appropriately. Furthermore, the simulations demonstrate reliable replications of both the variability of volatility and volatility clustering phenomena. The interdependence among carbon markets and other financial markets is effectively incorporated and modeled through a multivariate simulation. Not only the existing price gap between the Korean and the EU ETS markets but a probabilistic analysis based on the simulation suggests that the Korean ETS market is underpriced relative to carbon price prospects provided by major institutions. The probability of reaching the price levels projected by the institutions is estimated as low as below 15% while that of the EU ETS reaches up to over 40%. If we presume that the Korean ETS follows a trajectory similar to that of the EU ETS market’s historical evolution, the Korean ETS could potentially face a risk of price surges.