Does Speculation Matter in the Carbon Pricing Framework? Insights from the EU Emissions Trading System

Abstract

To align with the global goal of keeping temperature below [Formula: see text]C, a market-based initiative, “Emissions Trading System” (ETS), has been developed to mitigate climate change. However, while the carbon allowances traded at the ETS are mostly held and traded by polluting companies, financial actors engage in “speculation”, activities that might be detrimental to the functioning of the ETS have also invested in the ETS. By drawing from the big data archive of Google Trends, we construct a news-based speculation index to proxy for the role of speculation in the dynamics of carbon pricing. Given our preliminary finding of inherent volatility and the mixed-frequency nature of the dataset, we employ the GARCH-MIDAS econometric technique to test the hypothesis that an all-inclusive framework that reflects the emission compliance and emissions non-compliance dynamics of the ETS is the most accurate approach to modeling carbon prices. We show that higher speculation in the ETS fosters higher long-term volatility in carbon prices, that speculation is a good predictor of carbon prices, and that its positive impact on carbon price returns makes the ETS an attractive investment opportunity. We provide a data-driven framework upon which the growing debate about whether the behavior of the non-compliance emission actors in the ETS endangers or benefits the functioning of the ETS can be evaluated empirically.