An analysis of the EU Emission Trading Scheme

The European Union's Emissions Trading Scheme (ETS) is the key policy instrument of the European Commission's Climate Change Program aimed at reducing greenhouse gas emissions to eight percent below 1990 levels by 2012. A critically important
element of the EU ETS is the establishment of a market determined price for EU
allowances. This article examines the extent to which several theoretically founded factors including, economic growth, energy prices and weather conditions determine the
expected prices of the European Union CO2 allowances during the 2005 through to the
2009 period. The novel aspect of our study is that we examine the heavily traded futures instruments that have an expiry date in Phase 2 of the EU ETS. Our study adopts
both static and recursive versions of the Johansen multivariate cointegration likelihood
ratio test as well as a variation on this test with a view to controlling for time varying
volatility effects. Our results are indicative of a new pricing regime emerging in Phase
2 of the market and point to a maturing market driven by the fundamentals. These results are valuable both for traders of EU allowances and for those policy makers seeking
to improve the design of the European Union ETS.