Do Regulations Affect Carbon Market Returns and Volatility?

Abstract

If the carbon market is expected to be an effective instrument of emissions reduction, the observed market prices should reflect the important information regarding new regulations, availability of emissions permits and aggregate marginal costs of emissions reduction. This chapter tests the informational efficiency of European carbon market by conducting an event study of the effects of regulatory and other announcements on the carbon price and volatility. The analysis considers both supply-side and demand-side events that can be expected to affect prices and volatility of the emissions allowances. Generally, carbon market reacts to announcements in predictable way, with expected increases (decreases) in the supply of allowances resulting in a negative (positive) price reaction and expected increases (decreases) in the demand for allowances resulting in a positive (negative) price reaction. At the same time, not all announcements lead to a significant price impact. These results are robust to controlling for relevant factors, including oil and gas prices, stock market returns and weather conditions. With regard to the market volatility, the results show that it is largely unaffected by the various regulatory announcements. However, the dynamics of the option implied volatility indicates that the market uncertainty increases before scheduled events and decreases afterwards. There also exist a number of market reaction anomalies that suggest that, while largely well functioning, the EU carbon market is not perfectly informationally efficient.