Trading of Emission Allowances and Financial Frictions

Abstract

This paper examines the role of financial frictions on the trading of emission allowances. Our tests are based on a wide international sample of firms and data from the European Union Emission Trading System (EU ETS), which is the most liquid and developed in the world. We find evidence consistent with the notion that key features of the ETS (i.e., supply of allowances, compliance period, disclosure of transactions) combined with the current accounting for emission rights induce firms to sell emission allowances for financial reasons unrelated to compliance with environmental regulation. We observe more frequent selling of allowances when the transactions are likely to provide a liquidity and/or a reporting advantage (i.e., boosting earnings to avoid accounting losses). Additional tests suggest that the documented trading activity affects the functioning of the ETS; it is associated with deviations from standard compliance behavior, more selling intensity, and temporary effects on carbon pricing. Our results have implications for the debate on the institutional design of carbon markets.

Keywords: Financial frictions, Emission Trading, Emission Allowance, Pollution Pricing

JEL Classification: M10, M41, Q50