Cointegration analysis of fundamental drivers affecting carbon price dynamics in the EU ETS

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Abstract

This study employed co-integration methodology to explore the fundamental drivers of carbon price in the European Union Emissions Trading System (EU ETS) during the transition from phase III to phase IV, focusing on the interactions between the carbon market, energy sector, and macroeconomic factors. A novel approach of bilaterally modifying dummy variables was used to include the impact of regulatory event announcements on the EU carbon price. Long-term analysis revealed that coal prices exhibited a positive but statistically insignificant impact, while natural gas and oil prices show substantial and significant influences. Short-term dynamics indicated a self-adjusting mechanism, with gas and oil prices playing crucial roles. We found that the European stock market has a dampening effect on short-term carbon prices, whereas the commodity market exerted a counteractive force. In the energy sector, variations in European gas prices and shifts in nonrenewable electricity generation significantly influence short-term carbon price. Regulatory event announcements exhibited an overall negative and statistically significant trend. However, the relatively small magnitude of these coefficients underscored the modest impact of regulatory event announcements on short-term carbon prices within the EU ETS. Additionally, our study estimated the long-term equilibrium relationship between variables using ridge regression, serving as a proxy for the EU’s equilibrium carbon price. We examined the disparities between this equilibrium and market prices. Two distinct phases emerged in the analysis. Before April 2018, the market price consistently lagged behind the equilibrium, suggesting an overestimation of the value of carbon emission rights. Subsequently, the market price consistently surpassed the equilibrium. In particular, the sharp increase in carbon prices from April to June 2020, driven by the COVID-19 pandemic, highlighted the sensitivity of the EU carbon market to external shocks.

Keywords

EU ETS / carbon price / energy prices / cointegration

CHANGE HISTORY

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