Energy commodities spillover analysis for assessing the functioning of the European Union Emissions Trading System trade network of carbon allowances

Abstract

The European Union Emissions Trading System (EU ETS) is designed to promote carbon reduction in a cost-effective and economically efficient manner. To meet their compliance requirements, participants within the EU ETS can either invest in carbon abatement, thereby improving their environmental performances, or purchase carbon allowances from the market. Our analysis aims to investigate the structural features of the EU ETS trade network of allowances and assess its robustness to spillovers propagated from energy commodities. We build the EU ETS trade network of allowances on a daily basis by leveraging a granular dataset comprising over 32k accounts that performed approximately 720k trades, involving more than 127 billion of allowances from 2005 to 2020. Importantly, our analysis is able to cover entirely the first three phases of the EU ETS, thus providing an updated view on the functioning of the EU ETS. We find that the EU ETS trade network of allowances is disassortative and characterized by very active nodes belonging to the energy sector. Moreover, we detect that energy commodity transmission channels can be substantial and may shape the way nodes transfer allowances, with the configuration of the EU ETS often being a net receiver of spillovers. These findings are robust even when we analyze extreme quantiles of the distribution to account for distressed periods. Our study shows how the functioning of the EU ETS can be influenced by spillovers imported from energy commodity markets. We discuss how investors can build portfolios that either hedge or amplify the impact of such spillovers, depending on their risk appetite. Given that energy commodities are significant inputs in the production processes of energy firms—who are highly active participants in the trade network of allowances—analyzing market responses to shocks in energy commodities is crucial for the effective implementation of the policy.