Simulating and assessing carbon markets: Application to the Korean and the EU ETSs

Abstract

Emissions Trading Systems (ETS) play a critical role in determining the carbon price through market mechanisms, enabling us to assess financial risks faced by participants in the economy, quantitatively by modeling the market behavior. We offer a probabilistic market simulation framework that generates future price scenarios across multiple markets. This framework simulates carbon markets accurately with a Multi-CDF inversion approach coupled with GARCH volatility model. Without the restriction of a normal distribution assumption, atypical patterns of price movements in illiquid and immature markets are modeled appropriately. Furthermore, the simulations demonstrate reliable replications of complex volatility dynamics. The interdependence among carbon markets and other financial markets is effectively incorporated and modeled through a multi-market 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 simulated 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%. A comparison of the effective cap rates reveals that the restrictive strength of the Korean ETS policy remains relatively low, thereby limiting the stimulation of demand for carbon allowances. 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 significant upside risk in carbon price. © 2024 Elsevier Ltd