The Relationship between Spot and Futures CO2 Emission Allowance Prices in the EU-ETS

Abstract

In this paper we investigate the relationship between spot and futures prices within the EU-wide CO2 emissions trading scheme (EU-ETS). We conduct an empirical study on price behavior, volatility term structure and correlations in different CO2 EU Allowance (EUA) contracts during the pilot trading and the first Kyoto commitment period. We find that for the pilot trading period (2005-2007) the market was initially in backwardation, while after the news of sufficiently high allocations, both allowance prices and convenience yields approached zero. On the other hand, futures contracts referring to the Kyoto commitment period were less affected by the price drop. Considering spot and allowance futures prices during Phase II (2008-2012), we find that the market has changed from initial backwardation to contango with significant convenience yields in futures contracts. We attribute this deviation from the cost-of-carry relationship to three main factors: low interest rate levels in the Eurozone; market participants’ willingness to pay an additional premium for a hedge against rising prices in future periods, and, the increasing level of surplus allowances and banking during Phase II.

Keywords: CO2 Emission Trading, Commodity Markets, Spot and Futures Prices, Convenience Yields, Dynamic Semiparametric Factor Model (DSFM), Gibson-Schwartz Model

JEL Classification: C14, G13, Q28