The factors that determine the carbon price: an econometric analysis

Emission allowances are both physical and financial assets. The information gathered during the EU ETS system’s pilot phase (2005-2007), and since the beginning of Phase II (2008-2012) enables us to identify a certain number of factors that determine their price. As for any asset, it then becomes possible to study the potential gap between the value observed on the market and the value dictated by fundamentals.

Phases I and II of the EU ETS are different, both in terms of their assessment and their characteristics (liquidity and financial depth), and of the rules for regulating the carbon market. Given these differences, and the fact that not much research has been conducted on Phase II up until now, it is particularly appropriate to test whether the results and mechanisms highlighted for Phase I apply to Phase II. More specifically, are the determining factors identified for Phase I, like the energy price, various economic activity indicators, and the choice of fuel still valid when it comes to explaining the European allowance price from 2008 onwards? Do these determining factors change in function of a long-term, stable relationship with the CO2 price?

The econometric techniques of co-integration allows for the estimation of a long-term stable relationship between the price of CO2 and the fundamentals if one exists. By applying this technique to daily futures contracts data, we were first able to show that such a balance exists. Specifically, the trend in the CO2 price can be explained by the movements of three fundamentals, namely the price of unrefined crude (ICE Brent Futures Index), economic activity (for which the Euro Stoxx 50 stock market index is an approximation), and the cost of technological change (switch from gas to coal).

This balance between the price of the carbon allowance and its fundamentals is nonetheless different for both periods, and is characterised by the increasing role played by fundamentals during Phase II. However, calculating the equilibrium price obtained based on this relationship shows that European allowance prices have tended to be undervalued almost systematically since the end of 2009, and by up to 30% in late 2010. One of the reasons is that non-energy sectors were particularly affected by the slowdown in economic activity, which increases the allowance supply for the same level of demand, and leads to an imbalance close to the one observed at the beginning of Phase I. However, the gap between the prices observed and estimated values, which has appeared since 2009, cannot be completely explained by the impact of the financial crisis.

The reasons for this undervaluation seem to be more profound. First of all, they are linked to the uncertainty regarding the exact market operation rules for the period between now and 2020, and to the even greater uncertainty regarding the next phase. This uncertainty has been compounded by the incidents of fraud that occurred in early 2010, which significantly added to the lack of confidence among market players. In addition, supply-demand balance was made even more difficult to anticipate due to the potential use of Kyoto credits (CDM and JI credits), which contributed to an increase in the supply of carbon assets. Finally, a certain degree of uncertainty remains regarding the transition to a mostly auction-based scheme for Phase III of the EU ETS from 2013 onwards. This process could change players’ arbitrage procedures, on the one hand, but could also create an opportunity for the European Commission to set up a system to manage the carbon price through changing the allowance supply, on the other.

Our research suggests that the market needs greater clarity and predictability regarding its operating rules and the level of constraint that will affect the allowance supply in the long-term.