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Dynamic linkages among carbon, energy and financial markets: a smooth transition approach

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Abstract:

This article explores how price linkages between carbon allowances and market fundamentals in the EU Emissions Trading Scheme (EU ETS) vary over time. I adopt a multivariate GARCH model that allows the conditional correlation between carbon, energy and financial prices to change smoothly across regimes governed by functions of two transition variables that explain why price linkages vary. I use (i) time as transition variable to allow for structural changes associated with institutional advances in the EU ETS and (ii) implied volatility to account for heterogeneity in the behaviour of correlations in times of distress compared to calm periods. The results point to a new pricing regime with much closer carbon-energy price linkages in the second phase of the EU ETS. Furthermore, I find that correlations depend on market uncertainty conditions, which exposes the link between carbon and financial markets due to common macroeconomic shocks during the current financial crisis.

Keywords: C32; CO2 emissions trading; EU ETS; Q43; Q58; energy markets; multivariate GARCH; smooth transition

Document Type: Research Article

DOI: http://dx.doi.org/10.1080/00036846.2013.854301

Affiliations: School of Business, Economics and Social sciences, University of Hamburg, Hamburg, Germany

Publication date: March 3, 2014

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