Nonlinearity in Cap-and-Trade Systems: The EUA Price and its Fundamentals

Since the introduction of the EU Emissions Trading System (EU ETS) in 2005, a new area of research has developed within the field of applied econometrics: Carbon Finance. Carbon Finance focuses on the analysis of the price formation of emission credits and allowances. As driving cost factor, prices of European Union Allowances (EUAs) in uence operational business and long-term planning of EU ETS regulated firms. Therefore, the understanding of the EUA price dynamics are significant for practitioners, politicians and scientists. This paper contributes to the analysis of the relationship between the EUA price and its fundamentals, such as energy prices, indicators of the macroeconomic development and weather conditions in Europe. Based on a Markov regime-switching model, we estimate the nonlinear impact of these fundamentals on the EUA price. Further, the model allows to get insights into the development of the EUA price variation (volatility) over time.

Breaks and changes in the data generating process that underlies the EUA price time series are a consequence of the design of the EU ETS. Emissions trading schemes are characterized by a fixed supply of allowances, while the demand is subject to various shocks and changes. A sudden decline of economic activities, for example, leads to decreasing emissions and hence to a decreasing demand of allowances. As a consequence, this situation increases uncertainty among market participants about the overall stringency of the scheme. The associated trading leads to higher levels of EUA price volatility and to a changing relation between the EUA price and its fundamentals. The empirical model identifies two different market states (regimes), that determine the EUA price dynamics. The data generating process switches several times between these two regimes during the period under consideration, i.e. January 2008 to December 2012.

Both regimes are characterized by no clear price trend. The first regime shows high levels of EUA price variation. This state can also be interpreted as a market phase of high uncertainty. In contrast, the second regime describes a state where the variation in EUA prices is on a lower level. The results show, that energy prices and the stock market are important EUA price determinants in both regimes. The gas price and a broad European equity index affect the EUA price positively in both regimes, while the coal price and the oil price have a significant, but also positive impact only during the high and the low volatility regime, respectively. Extreme temperatures have no significant in uence on the EUA price. The high volatility regime is predominant in phases when economic activities are on a decrease or when institutional changes harm the confidence in the stringency of the EU ETS. This holds during the recession of 2008 and 2009, as well as during 2011 and 2012 when the debt crisis impaired the European economic outlook.

The results of the empirical examination support the hypotheses, that the EUA price dynamics are characterized by breaks and changes. The impact of fundamentals on the EUA price and the development of its variation over time are subject to this kind of nonlinearity.

Lutz, Benjamin Johannes, Uta Pigorsch and Waldemar Rotfuß (2013), Nonlinearity in Cap-and-Trade Systems: The EUA Price and its Fundamentals, ZEW Discussion Paper No. 13-001, Mannheim.