Evaluating the carbon-macroeconomy relationship: Evidence from threshold vector error-correction and Markov-switching VAR models

Abstract

This paper studies the nonlinear adjustment between industrial production and carbon prices – coined as ‘the carbon-macroeconomy relationship’ – in the EU 27. We model carbon price returns and industrial production as nonlinear and state-dependent, with dynamics depending on the sign and magnitude of past realization of returns and the growth of industrial production. Our findings show that (i) macroeconomic activity is likely to affect carbon prices with a lag, due to the specific institutional constraints of this environmental market; (ii) the joint dynamics of industrial production and carbon prices seem adequately captured by two-regime threshold vector error-correction and two-regime Markov-switching VAR models compared to linear models as main competitors. The regime-switching models proposed are profoundly checked for their economic content and statistical congruency, and are found to provide a sound statistical framework for a comprehensive analysis of the carbon-macroeconomy relationship.