Integration of the international carbon market: A time-varying analysis

Abstract

Emission Trading Schemes (ETSs) have become vital for meeting global emission reduction targets. They are gaining momentum, as witnessed by increasing market size and improving information mechanisms. Examining key emission markets — European Union, New Zealand, California, and Hubei (China) — from April 2014 to December 2021, a Time-Varying Parameter Vector Autoregressive (TVP-VAR) model is applied to discern the markets' connectedness. In a novel approach to global carbon market research, this study uniquely combines the TVP-VAR with the connectedness approach, overcoming fixed parameters estimation and ensuring precise parameter estimates. The approach sheds light on patterns of total, directional, and net return/volatility spillovers, striving to identify which markets act as transmitters and which are receivers. Linking market spillovers to market characteristics, events, and policies offers insights for investors and policymakers. The total connectedness index of 10–12 % suggests a relatively low level of spillover, when compared to other market integration studies. The dynamic nature of return and volatility spillovers is evident, especially during the energy crisis and Covid-19 outbreak. The EU's ETS consistently acts as a net transmitter, predominantly in return connectedness, while New Zealand's ETS emerges as a major shock receiver in both return and volatility systems. Global climate negotiations and carbon market events have only a minor impact on the level of connectedness, in contrast to energy or financial crises and the Covid-19 outbreak. By highlighting the intricacies of carbon price volatility and market transmissions, the findings equip stakeholders with invaluable, actionable insights.