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Abstract:
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As part of the European Union key policy aimed at reducing greenhouse gas emissions (GHG) –
European Union Emission Trading Scheme (EU ETS) was launched in January 2005. Following
this initiation, a new investment asset was introduced to the market – European Union
Allowance (EUA) – a right to emit a ton of CO2. The establishment of the European carbon
system created a new type of risk – carbon risk, to which more and more companies and
investors are becoming to be exposed.
Despite the growing importance of the carbon market in investment and risk management, the
available research of the topic remains limited. Although a handful lot of papers, investigating
EU ETS Phase I, have been issued, the empirical research on Phase II remains scarce. The aim of
this paper is to shed more light on the new structure of the market and different factors affecting
market participants’ carbon risk, as well as provide a thorough analysis of their interdependency,
and offer some insight for risk management purposes.
By looking for a presence of a stochastic trend, Hotelling rule and cost-of-carry relationship we
establish a methodology to check the efficiency of the EU ETS market. We conclude that current
market setting is inefficient and intertemporal arbitrage opportunities are present. By
implementing correlation, cointegration and copula methods, we conclude that EUAs futures are
a suitable instrument to hedge away carbon risk. We propose implementation of copula approach
in the calculation of Value-at-Risk metric as well as optimal hedge ratio for the sound risk
management practices. |
