The efficacy of the European Union Emissions Trading Scheme: depicting the co-movement of carbon assets and energy commodities through wavelet decomposition

Abstract

Environmental system thresholds have been crossed for a number of dimensions of global environmental pollution, such as greenhouse gas emissions. Under this scenario, institutions and corporations are required to implement sustainable policies as a condition for humanity staying within planetary boundaries. Accordingly, the European Union created the largest Emissions Trading Scheme in the world with the aim of properly managing corporations' carbon dioxide reductions. This paper aims to contribute to the literature focused on testing the effectiveness of institutional environmental management policies. Specifically, this research evaluates whether the objectives of the European Union Emissions Trading Scheme are partially achieved by analyzing the dynamics of carbon assets and the main energy commodities worldwide. This paper provides relevant information both for policy makers and company managers so that contributions towards the common goal of developing a clean energy future and curbing climate change are ameliorated. Based on wavelet coherence analysis, this paper proposes a model-free way of estimating the time-varying correlations between carbon assets and energy commodities at both high and low frequencies. Our central results reveal that carbon assets and energy commodities present a changing lead/lag behavior at different frequencies. The energy commodities lead the European Union Allowances returns at medium frequencies, but the contrary was true for the highest investment horizons. This finding should be in line with the goal of significantly reducing emissions because during long cycles if the majority of companies have not switched to cleaner industrial processes, they must buy more carbon assets, increasing their prices. In that case, energy commodities would be more expensive because of the energy commodities' market behavior during long-term horizons with European Union Allowances lead. The Certified Emissions Reductions lead in a negative way most of the energy commodities at medium frequencies, thus indicating that investors handling energy commodities-oriented portfolios could incorporate the mentioned carbon assets for diversification purposes. These specific findings suggest that polluting activities would be more expensive, which would provide an incentive to companies to implement environmentally–friendly industrial processes. The European Union Emissions Trading Scheme can result in significant emission reductions and compliance of the European Union with the objectives of the Kyoto Protocol.