Modelling the Dynamics of Fuel and EU Allowance Prices during Phase 3 of the EU ETS

M Carnero,Jose Olmo,Lorenzo Pascual

doi:10.3390/en11113148

Abstract

This article studies the relationship between the prices of fuel and EU Allowances (EUA) for carbon emissions during Phase 3 of the European Union Emissions Trading System. We find that the forward prices of EUA, coal, gas and Brent oil are jointly determined in equilibrium. The existence of such a long-run relationship entails a permanent-transitory decomposition for the series of EUA and fuel prices that reveals the short- and long-term causal influence of the EUA market in shaping the joint dynamics of fuel prices. This result complements the literature that suggests that EUA prices are driven by the dynamics of fuel prices. Interestingly, we do not find an equilibrium relationship in the spot market. EUA and fuel spot prices are driven by independent unit root processes. The differences between spot and forward markets are attributed to the tradability of forward prices that are used for speculation and hedging in financial markets. In contrast, spot prices are mainly driven by supply and demand in energy markets.

Highlights

The European Union Emissions Trading System (EU ETS) is a key tool for reducing greenhouse gas emissions and the world’s first and biggest carbon market
This paper studies the relationship between the prices of EU carbon emission allowances and fuel prices, in particular, coal, gas and Brent oil during Phase 3 of the EU ETS
We have explored long-run and short-run relationships using a dynamic vector autoregressive process (VAR) specification for the time series of log-prices for spot and forward markets

Summary

Introduction

The European Union Emissions Trading System (EU ETS) is a key tool for reducing greenhouse gas emissions and the world’s first and biggest carbon market. It works on the ‘cap and trade’ principle. 11,000 power plants and manufacturing installations (power stations, oil refineries, production of iron, aluminium, cement, lime, glass, ceramics, etc.), as well as approximately 520 airlines flying in Europe. It covers around 45% of the EU’s greenhouse gas emissions. We refer to Goulder and Parry [1], Aldy and Stavins [2] and Baranzini et al [3] for a deep discussion on carbon pricing policies and to Aldy and Stavins [2] and Ellerman et al [4] for a review on the EU ETS performance during the last few years

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