Carbon pricing in the EU: fundamentals or market sentiment?

Abstract

The determinants of secondary-market price changes in the EU emission allowances (EUAs), the main carbon-pricing tool in the European Union, are still largely unknown. Using a VAR model that combines data at different frequencies and exploits shock-based restrictions, we investigate the role of four potential drivers: i) EUA supply and, more in general, carbon policy; ii) the business cycle; iii) the emission intensity of output; iv) market sentiment or financial factors. According to our model, carbon policy and financial factors explain the bulk of the variability in EUA prices, while the business cycle and the emission intensity play a more marginal role.

Keywords: emission trading scheme, VARs, real-time decomposition, EU allowances, shocks-based restrictions

JEL Classification: E32, Q41, Q58