The price impacts of linking the European Union Emissions Trading Scheme to the Clean Development Mechanism

Abstract

Many countries have begun to look increasingly toward the Clean Development Mechanism (CDM) as one of the key tools to increase the cost effectiveness of fulfilling their compliance requirements with the Kyoto Protocol. It is believed, from a theoretical point of view, that linking emissions trading schemes to the Kyoto Protocol’s flexible mechanisms can lead to a decrease in carbon prices and so a reduction of the overall compliance costs. This study provides an analysis of the relationship between the European Union Emissions Trading Scheme (EU ETS) and the CDM. The study considers the dynamic interactions between European allowance (EUA) prices and certified emission reduction (CER) prices, and uses time-series econometric techniques to test for the existence of long-term links and causal relations between the prices. Furthermore, the generalized impulse response analysis has been used to investigate temporal interactions among the variables. The results show that CER prices do not have a statistically significant effect on EUA prices; rather, it is the EUA prices that have driven CER prices during the period investigated. The constraint on the availability of CERs emanating from supplementarity and additionality criteria, as stipulated by the Kyoto Protocol, is one of the major factors that can be hypothesized to account for this finding.