Price Discovery in Carbon Markets: Evidence from Phase III & IV of EU-ETS

Abstract

This paper examines the price discovery process in the European Union Emission Trading Scheme (EU-ETS) – the largest carbon market across the world – for its third and fourth commitment periods. In particular, we examine the two leading carbon exchanges: European Energy Exchange (EEX: Spot and Futures) and European Climate Exchange (ECX: Futures). We examine the information transmission process in the EU-ETS for the three pairs, namely, (I) EEX spot-EEX futures, (II) EEX futures-ECX futures, and (III) EEX spot-ECX futures. To this end, we employ all three pair-wise bivariate vector error correction models (VECM) and price discovery measures, that is, component share (CS), information share (IS), and information leadership share (ILS) measures. We show that all three-price series substantially contribute to the price discovery. Moreover, the speed of adjustment and price discovery is comparable to the developed equity markets. The ability of carbon prices to incorporate the risk-premia related to climate-risk considerably depends on the pricing efficiency of carbon – one of the major objectives of the Kyoto Protocol and EU-ETS. Thus, these results have significant implications for policymakers, regulators, and academics in the forthcoming carbon markets from emerging economies (e.g., China, India).