Market Efficiency and Price Discovery in the EU Carbon Futures Market

Abstract

We examine the issues of market efficiency and price discovery in the European Union carbon futures market. Our findings suggest that none of the three carbon futures contracts examined here are priced according to the cost-of-carry model, although two of the three contracts form a stable long-run relationship with the spot price and interest rates, and hence act as adequate risk mitigation instruments. In terms of information diffusion between the futures and spot contracts, it appears that the spot and futures markets share information efficiently and contribute to price discovery jointly. However, our analysis suggests that the predominant source of information spillovers appears to be the sign or direction of price change, i.e. return spillover, rather than the magnitude of price change, i.e. volatility spillover.

Keywords: Carbon-Dioxide Allowances, Futures, Cost-of-Carry, Price Discovery, Market Efficiency, Cointegration, Granger Causality, Volatility Spillover, Global Warming

JEL Classification: C32, G13, G14, C32, Q25, Q40