Pricing of carbon emission allowances An assessment of the pricing relationships and the adequacy of EU ETS as a climate policy tool

Abstract

The purpose of this study is to shed light on the pricing mechanisms within the EU Emissions Trading System and evaluate the link between the prices of emission allowances and the prices of fundamental drivers of greenhouse gas emission. Through the use of an extensive model framework, we prove that there exists a long-run relationship between the spot and futures prices of emission allowances and make relatively accurate predictions of future spot prices based on historical price information. This implies that futures prices work as a signi cant information vehicle and that the system exhibits the appropriate risk mitigation characteristics for hedging greenhouse gas emission. Moreover, we identify links between prices of emission allowances and prices of coal, Brent oil and the DAX. Impulse response functions indicate that the system reacts to shocks in these variables but that the shocks are neutralized relatively fast. Overall, we nd evidence of a system exhibiting the characteristics of a mature nancial market