Modeling the relationship between European carbon permits and certified emission reductions

Koop, Gary and Tole, Lise (2013) Modeling the relationship between European carbon permits and certified emission reductions. Journal of Empirical Finance, 24. 166–181. ISSN 0927-5398 (https://doi.org/10.1016/j.jempfin.2013.10.005)

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Abstract

Recent years have seen an expansion of carbon markets around the world as various policymakers attempt to reduce CO2 emissions. This paper considers two of the major types of carbon permits: European Union Allowances (EUAs, arising from the European Union Emissions Trading Scheme, EU ETS) and certi…ed emissions reductions (CERs, arising from agreements made under the Kyoto Protocol). The rules of the EU ETS allow for some use of CERs in place of EUAs by EU …rms, but this substitutability is only partial. Allowing for carbon permits from di¤erent sources to substitute for one another should help achieve CO2 emissions reductions at least cost. Understanding the degree and nature of linkages (if any) between the markets for EUAs and CER is, thus, an important policy issue. In this paper, we jointly model the spot and future prices of an EUA along with the price of a CER using ‡exible multi- variate time series methods which allow for time-variation in parameters. We …nd evidence of contemporaneous causality between these three variables with the EUA futures price playing the dominant role in driving this relationship. We also document time-variation in this relationship which is associated with macroeconomic events such as the …nancial crisis of late 2008 and early 2009. We …nd very little evidence of volatility spillovers or of Granger causality among any of the variables. We discuss how these empirical …ndings are consistent with markets which are loosely linked, but are not tightly linked as would be found for perfectly substitutable assets in e¢ cient …nancial markets.

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