Modeling the Price Spread between the EUA and the CER Carbon Prices

Abstract

Linking the European Union Emissions Trading Scheme (EU ETS) to the Clean Development Mechanism (CDM) indicates a recognition of credits generated under the CDM projects, Certified Emission Reductions (CERs), as equivalent to European allowances (EUAs). Therefore, CERs are expected to be fully fungible for compliance within the EU ETS and hence arbitrage ensures the equality of prices. However, EUA prices exceed CER prices. Prior studies on the price spread between the EUA and the CER have so far relied on the assumption of fixed structural relationship. Empirical evidence from the dynamics of the price spread is missing. In this paper, I address this gap and analyse the process that describes the dynamic evolution of the price spread by employing a time-varying parameter analysis, in addition to standard techniques. This paper explicitly detects changes in the structural relationship in order to scrutinise the strength of price convergence and to identify factors impacting on the dynamics of the price spread. The simultaneous use of multiple measures maximises the accuracy of investigation. The results demonstrate that a price convergence cannot be found between these two compliance tools over the period considered. The analyses find that different market frameworks of CERs and EUAs, a cap on the amounts of CERs, the regulatory changes concerning both EUAs and CERs, the adoption of Phase III and the lack of its clarity regarding the use and the availability of CERs within the EU ETS, and uncertainty surrounding CERs with respect to the default risk of financial institutions who guaranteed secondary CERs can be considered as the primarily factors underlying the price spread.