Abstract
We investigate liquidity and market efficiency on the world's largest carbon exchange, IntercontinentalExchange Inc.’s European Climate Exchange (ECX), by using intraday short-horizon return predictability as an inverse indicator of market efficiency. We find a strong relationship between liquidity and market efficiency such that when spreads narrow, return predictability diminishes. This is more pronounced for the highest trading carbon futures and during periods of low liquidity. Since the start of trading in Phase II of the EU Emissions Trading Scheme (EU-ETS) prices have continuously moved nearer to unity with efficient, random walk benchmarks, and this improves from year to year. Overall, our findings suggest that trading quality in the EU-ETS has improved markedly and matures over the 2008–2011 compliance years.
Highlights
The EU Emissions Trading Scheme (EU-ETS) is both the largest compulsory cap and trade scheme in the world and the most potent regional climate change policy tool arising from the EU’s 2002 ratification of the Kyoto protocol, a global treaty on greenhouse gas emission reduction.1 The operation and success of the EU-ETS will significantly inform the direction of global climate policy, identifying effective mechanisms for carbon trading and the effect of different restrictions on the price of emissions
In this paper, where we identify the commencement of compliance years as an exogenous event corresponding to the tightening of trading spreads, a confirmation of the liquidity-return predictability link would imply that increased trading activity induced by EU policies could improve EU-ETS pricing efficiency
There are about 17 other compulsory schemes elsewhere in the world, the success of the EUETS would still provide a strong impetus for the formulation of a truly global market-driven climate change policy given that it drives more than 90% of global carbon trading
Summary
The EU Emissions Trading Scheme (EU-ETS) is both the largest compulsory cap and trade scheme in the world and the most potent regional climate change policy tool arising from the EU’s 2002 ratification of the Kyoto protocol, a global treaty on greenhouse gas emission reduction. The operation and success of the EU-ETS will significantly inform the direction of global climate policy, identifying effective mechanisms for carbon trading and the effect of different restrictions on the price of emissions. The operation and success of the EU-ETS will significantly inform the direction of global climate policy, identifying effective mechanisms for carbon trading and the effect of different restrictions on the price of emissions. The scheme may affect the growth of the emission-constrained economies in Europe, New Zealand, the United States, Japan and other parts of the world. This is because regulatory arbitrage is likely to be greater when carbon trading is limited to significantly smaller geographical locations, as is the case at this time. The EU opted mainly to employ the emissions trading mechanism, as the EU-ETS (see Ellerman, Convery, and De Perthuis, 2010, Labatt and White, 2007)
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