An Econometric Analysis of Emission Trading Allowances

Abstract

World power and gas markets have a natural relationship with global tradable carbon permits markets, including the U.S. Clean Air Act Amendments and the EU Emissions Trading Scheme, the latter officially launched in January 2005. Electric utilities operate their power plants based in part on the price of the power and the relative cost of coal and natural gas. As both carbon dioxide and sulphur dioxide are by-products of the coal burning process, the new factors of SO2 and CO2 emissions allowances come into play in a carbon constrained economy. Now that a price has been put on such allowances, the differences in carbon intensity for coal and gas could potentially change the way companies run their power plants. Moreover, knowledge of the statistical distribution of emission trading allowances, and its forecastability, becomes crucial in constructing optimal hedging and purchasing strategies in the carbon market. This paper provides an in-depth analysis of available data addressing the unconditional tail behavior and the inherent heteroskedastic dynamics in the returns on the emissions allowances.

Keywords: Environmental Finance, GARCH, Greenhouse Gases, Mixture Models, Tail Estimation

JEL Classification: C16, C32, C51, C52, C53