Revisiting the Framework for Modelling Carbon Allowances: The Role of Speculation in Some Forecasting Experiment?

Jianjie Huang, Kazeem Isah, Oladotun D. Olaniran and Mohammed N. Ibrahim

Australian Economic Papers, 2026, vol. 65, issue 1, 59-71

Abstract: To align with the global goal of keeping temperature rise well below 2°C, the European Emissions Trading System (EU‐ETS) was established as a market‐based initiative to mitigate climate change. While most carbon allowances are held and traded by polluting companies for compliance, financial actors including banks, investment firms, and brokers have increasingly participated as non‐emission compliance agents (ENCAs), engaging in speculative activities that may affect market functioning. Despite widespread discussion, compelling empirical evidence on the role of speculation in carbon price dynamics has been limited. Drawing from a large Google Trends dataset, we construct a news‐based speculation index to quantify speculative pressures and integrate it into an all‐inclusive modeling framework that accounts for both emission compliance and non‐compliance dynamics. Given the inherent volatility and mixed‐frequency nature of the data, we employ the GARCH‐MIDAS model, which accommodates variables at their natural frequencies while capturing both short‐ and long‐term volatility. Our out‐of‐sample forecasts show that models incorporating speculation and composite indicators consistently outperform the benchmark GARCH‐MIDAS‐RV model in returns, volatility, and Sharpe Ratios. Speculation emerges as a significant driver of risk‐adjusted performance, particularly over medium‐ and long‐term horizons, indicating that non‐compliance actors materially influence EUA price formation. The findings have clear economic and policy implications. Regulators can use data‐driven estimates of speculation to guide market participation rules and maintain stability, while investors can enhance portfolio performance by integrating speculative signals into forecasting models. Overall, the study provides a comprehensive, economically meaningful understanding of carbon price dynamics, reconciling market fundamentals with speculative activity and informing both policy and investment strategy in the EU‐ETS.

Date: 2026
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