«A Microstructure Analysis of the Carbon Finance Market Don Bredin Stuart Hyde ∗ University of Manchester† University College Dublin Cal Muckley ...»
A Microstructure Analysis of the Carbon Finance
Don Bredin Stuart Hyde
University of Manchester†
University College Dublin
University College Dublin‡
The European Union’s Emissions Trading Scheme is the key policy instrument of the
European Commission’s Climate Change Program aimed at reducing greenhouse gas
emissions to eight percent below 1990 levels by 2012. The key asset traded under the
scheme is the European Union allowance (EUA). This article examines the extent of the development in the futures market of the EU Emissions Trading Scheme. Using ultra high frequency data we ﬁnd considerable evidence that the market has developed since its establishment in 2005. Our results indicate signiﬁcant developments consistent with sequential information arrival with a negative contemporaneous relationship between volume and volatility for all contracts. The implication is that liquidity traders dominate any role played by informed traders. Incorporating the duration between trades in our analysis has signiﬁcant impact suggesting that any empirical investigation of the intra-day volume-volatility relationship needs to actively account for the impact of time elapse between trades.
Keywords: CO2 emissions allowances, Futures, Emissions trading, Energy, Kyoto Protocol, Market microstructure.
JEL Classiﬁcation: G13, G14, G19.
∗ E-mail: firstname.lastname@example.org † E-mail: email@example.com ‡ E-mail: firstname.lastname@example.org. Corresponding author: Cal Muckley, School of Business, University College Dublin, Blackrock, Dublin, Ireland. The authors would like to thank Michael Brennan, John McConnell, Maureen O’Hara and Matthew Spiegel for valuable comments and participants at the 2009 Global Finance Academy Conference at University College Dublin and at the 2009 ﬁnsia/MCFS Conference, Melbourne.
Ike Johnson provided research assistance.
1 Introduction In January 2005 the European Union (EU) introduced formally the emissions trading scheme (ETS). The scheme forms a central part of the EU agreement to cut worldwide emissions of carbon dioxide (CO2 ) within the Kyoto Protocol.1 Under the Kyoto agreement, the EU is committed to reduce greenhouse gas (GHG) emissions by eight percent (relative to 1990 levels) by 2012. The aim of the EU to reduce emissions by 2012 through the EU ETS is to be achieved via two phases. The ﬁrst Phase (Pilot) of trading was 2005and the second one (Kyoto), which coincides with the ﬁrst compliance period of the Kyoto Protocol, is 2008-2012. After these two initial phases, the third European trading Phase will commence in 2013.
The emissions trading scheme issues a restricted amount of emission allowances to ﬁrms on an annual basis. At the end of each year ﬁrms must hold the required amount of emission permits to meet their emissions of CO2 over that year.2 The ETS facilitates trades for ﬁrms that are either long or short on emission permits. Non-compliance with the commitments will result in a penalty of A 40 (A 100) per tonne of CO2 produced during the C C ﬁrst (second) commitment period. The aim of the ETS is to generate a price signal that will encourage ﬁrms to reduce their emissions. Paolella and Taschini (2008) emphasize that the ultimate aim of this scheme (as well as the US CAAA-Title IV scheme) must be to create an environment where there is scarcity of allowances which will lead to an upward trend in prices. There has been a considerable amount of uncertainty associated with the price of CO2 emissions over its short life to date.3 Convery and Redmond (2007) highlight that while emissions reduction has been the principal aim for the Kyoto Phase, the main objective of the Pilot Phase was to get the scheme up and running and speciﬁcally that it would be fully operational by 2008, the start of Phase 2 (Kyoto Phase).4 Given that markets (both spot and future), registries Member states of the European Union ratiﬁed the Kyoto agreement in May, 2002. The agreement became legally binding on February 16, 2005.
Firms are required to submit a report verifying their emissions in any year by March 31st of the following year. In addition, emission allowances cannot be banked for future periods.
The trading scheme also provides developing business opportunities for intermediaries and service providers. The pricing behavior of CO2 emissions is particularly important to these players and is examined in detail by Bredin and Muckley (2011).
Ellerman and Buchner (2006) estimate that the Phase 1 ETS has been responsible for reducing CO2 and monitoring, reporting and veriﬁcation has been established, one may argue that the principal aim of Phase 1 has been achieved. The volumes (both physical and monetary value) being traded on the European Climate Exchange (ECX) have grown dramatically since 2005. Between 2005 and 2008, physical volume increased from 94 million to 2.8 billion tonnes of CO2 being traded, while the monetary value increased from A 2.1 billion to over C A 55.9 billion.
C This paper examines the performance of the EU ETS from a market microstructure perspective with the aim of understanding the information assimilation process, liquidity and the degree of market eﬃciency during both the Pilot and the initial period of the Kyoto Phase.5 An examinination of both the Pilot and the initial period of the Kyoto Phase is important. An understanding of the initial setting up period of the exchange may have relevant and signiﬁcant implications for future exchanges or trading schemes, as well as subsequent periods of the EU ETS. For example, emissions trading systems are to be established in six regions in China by 2013 and nationwide by 2015 to reduce China’s emissions intensity relative to its GDP. The adopted microstructure approach provides the ﬁrst thorough indication, using volume, volatility and trade duration, of the initial performance of the EU ETS.
Price and volume behavior provide key insights into the structure and running of ﬁnancial markets. They are particularly informative with respect to the rate of information inﬂow, how information is being disseminated and the extent to which market prices convey the information. From an empirical research perspective the volume-volatility relationship has implications on the empirical distribution of speculative prices. The mixture of distributions hypothesis (MDH) asserts a joint dependence of volume and volatility on the underlying information ﬂow (see, inter alia, Clark, 1973; Tauchen and Pitts, 1983; Anderson, 1996). Alternatively, while the MDH does not allow for serial dependence between volume and volatility – it is a contemporaneous relationship, the sequential information arrival hypothesis (SIAH) (Copeland, 1976) posits that traders both receive information and act on it in a sequential manner, hence a new equilibrium is not established instantaneously and the potential for a lead-lag relationship between volume and volatility exists.
Moreover, the role of duration during these periods has hitherto not been explored. Yet emissions by between 50 and 200 million tonnes.
Our interpretation of eﬃcient markets draws on the work of Dacorogna et al. (2001).
while microstructure models (see Diamond and Verrecchia, 1987; Easley and O′ Hara, 1992) suggest trade arrival times convey information neither hypothesis explicitly accounts for the eﬀect of time duration in measuring the information content of trades.6 The microstructure literature acknowledges that trading activity in asset markets is induced by both revisions to investor expectations of asset prices, following the arrival of new information, and by their requirements for liquidity (see, O′ Hara, 1987 and Blume et al., 1994). Recent research into the analysis of trading volume as a measure and signal of investor information and liquidity needs, raises important issues concerning its interaction with other key variables of the trade process, in particular asset price volatility and trade duration. Duration is considered to reﬂect the trading strategy of informed traders or be an indicator of liquidity. Market microstructure suggests a relation between trade duration, trade volume and asset price volatility. However, prior empirical research customarily focuses upon the price impact of one or two speciﬁc trade process variables in isolation, rather than their combined eﬀects. In order to understand the full dynamic interactions among the three trade process variables they should be modeled simultaneously. We adopt such an approach in this paper to examine the information assimilation process, liquidity and the degree of market eﬃciency during the Pilot and the Kyoto Phase of the EU ETS.
We initially adopt the duration based model proposed by Xu et al (2006) to examine the relationship between time consistent volume and volatility, while controlling for exogenous duration eﬀects. In addition, we adopt an alternative model speciﬁcation, in the vein of Manganelli (2005), which allows duration to be endogenous and to be modelled simultaneously together with volume and volatility. Our analysis is carried out on Phase 1 and 2 EU ETS futures and we focus on futures data provided by the ECX.7 Our key results indicate signiﬁcant market developments, with reduced frictions indicating evidence of greater levels of eﬃciency and evidence of sequential information arrival in existence. The evidence of reduced market frictions is reﬂected in the form of reduced duration, higher volumes traded, lower volatilities and greater levels of bi-directional causality. In particular, taking account of the duration information, we ﬁnd that trades associDuration is deﬁned as the elapsed time between consecutive trades.
Futures contracts account for 76% of the volume of trades in EUA’s. Of these contracts, 96% are traded on ECX which was acquired by the Intercontinental Exchange in July 2010. The remainder are traded on the European Energy Exchange (EEX) and Nordpool (see Mansanet-Bataller and Pardo, 2008).
ated with longer durations have a higher impact on volatility. Our results also indicate a negative contemporaneous relationship between volume and volatility for all contracts examined. The implication is that liquidity traders dominate any role played by informed traders (Easley and O′ Hara, 1992). Moreover, the empirical evidence appears consistent with the sequential information arrival hypothesis (Copeland, 1976) rather the predictions of the mixture of distribution hypothesis (Clark, 1973; Tauchen and Pitts, 1983). The evidence in favor of the sequential information arrival hypothesis is consistent with recent results on the EU ETS reported by Conrad et al. (2011).
The remainder of the paper is set out as follows: section 2 discusses the emergent literature in carbon ﬁnance with speciﬁc reference to the ECX and microstructure issues.
Section 3 introduces the empirical methodology, outlining the adopted approach to study market microstructure issues from both a theoretical and empirical perspective. Section 4 presents the data and empirical results and section 5 provides some concluding comments.
2 Recent Developments in Carbon Finance
Futures contracts were introduced on the European Climate Exchange (ECX) in March 2005, with options trading following in October 2006. Trades on the ECX are cleared through the Intercontinental Exchange (ICE), which also hosts the electronic marketplaces for the Chicago Climate Exchange, with delivery of allowances at any national EU registry.8 Since 2005, the ECX has witnessed dramatic growth in trade volume. In March 2008 it introduced certiﬁed emission reduction (CER) futures and options and in October 2008 it introduced an EUA-CER spread trade.9 Despite the premature nature of the EUA market there has been a plethora of studies in recent years examining the pricing behavior and developments in both the spot and futures markets. Redmond and Convery (2006) examine EU ETS using daily data over the period 1st December 2004 to 31st July 2006 focussing on the behavior of the price of carbon in relation to energy commodities, meteorological factors and a number of other variables inIn late April 2010, the Intercontinental Exchange (ICE) agreed to pay over US$600 million in cash to acquire Climate Exchange (owner of the ECX) for which it previously cleared trades.
Mizrach and Otsubo (2011) investigate the price discovery between the EUA and CER futures on the ECX.
cluding dummy variables to take account of policy and regulatory issues. Similarly, Alberola et al. (2008) and Bredin and Muckley (2011) further document the role of fundamentals on daily spot and futures prices respectively. Paolella and Taschini (2008) examine both SO2 (in the US) and CO2 (EU) spot price dynamics, Benz and Tr¨ck (2009) take account u of the non-normality associated with the EU allowance returns on spot contracts ﬁnding evidence of regime switching while Daskalakis et al. (2009) examine the price behavior of spot, futures and options contracts across the diﬀerent phases and in three of the European trading venues. The empirical studies to date have highlighted the diﬃculties associated with Phase 1 (Pilot Phase). In particular there was considerable uncertainty associated with the market price of EUA’s. In April 2006, coincident to the unoﬃcial release of the 2005 emissions data by some of the EU member states the EUA’s price collapsed. EU ETS spot prices had reached a high of A 30.50 prior to April 2006. Following the oﬃcial release C by the EU commission on the 15th May 2006, showing a larger than expected surplus in the market, the spot price fell to A 15.63 on the 17th May 2006. Given that banking EUAs C was prohibited between phases, the price eventually converged to close to zero at the end of Phase 1. Overall for Phase 1, it would appear that the cap placed on emissions was far too lax and so downward pressure on the price continued.