Understanding the Dynamics of the European Carbon Markets1

Carbon permits and associated …nancial derivatives are increasingly traded in …nancial markets. E¢ ciently functioning carbon markets are necessary if reductions in CO2 emissions are to be achieved in a cost-e¤ective manner. With these considerations in mind, this paper adds to the growing literature which seeks to understand the operations of the carbon markets. We jointly model the spot and future prices of a European Union (EU) carbon permit along with the price of a carbon o¤set using ‡exible multivariate time series methods which allow for time-variation in coe¢ cients. We …nd evidence of contemporaneous causality between these three variables with the EU futures price playing the dominant role in driving this relationship. We also …nd some evidence of volatility spillovers, particularly between the EU future and spot markets. However, we …nd little evidence of Granger causality among any of the variables. We also document time-variation in these relationships which is associated with macroeconomic events such as the …nancial crisis of late 2008 and early 2009. Keywords: carbon trading, spot and futures markets, time-varying parameter VAR, stochastic volatility JEL Classi…cation Codes: C11, C32, C58, G12, G17, Q54