Table Of ContentEconometric Analysis of Carbon Markets
Julien Chevallier
Econometric
Analysis of Carbon
Markets
The European Union Emissions Trading
Scheme and the Clean Development
Mechanism
Dr.JulienChevallier
CGEMP/LEDa
DepartmentofEconomics
UniversityParisDauphine
PlaceduMarechaldeLattredeTassigny
75016Paris
France
[email protected]
ISBN978-94-007-2411-2 e-ISBN978-94-007-2412-9
DOI10.1007/978-94-007-2412-9
SpringerDordrechtHeidelbergLondonNewYork
LibraryofCongressControlNumber:2011938668
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To myfamily.
Preface
The idea of writing this book naturally came after a discussion with my editor,
whom I warmly thank for making this project possible. This book should be ex-
tremelyusefulforresearchersandworkingprofessionals(tradingmanagers,energy
and commodity traders, quantitative analysts, consultants, utilities) in the fields of
econometrics and carbon finance. We define carbon markets as the environmen-
talmarketscreatedtoregulatetheemissionsofgreenhousegases(includingCO ),
2
such as the European Union Emissions Trading Scheme (EU ETS) and the Kyoto
Protocol(morepreciselytheCleanDevelopmentMechanism,CDM).
Thisbookisintendedforreaderswithabasicunderstandingoftimeseriesecono-
metrics(suchasthelinearregressionmodel,vectorautoregression,andcointegra-
tion).UsefultextbookstorefreshconceptsonthismatterareGujarati(BasicEcono-
metrics, McGraw-Hill) and Hamilton (Time Series Analysis, Princeton University
Press).Itcanbeusedforteachingeconometricsappliedtocarbonmarketsatunder-
graduateorpostgraduatelevels(M.Sc.,MBA),andasareferenceforprofessionals.
Thecontentofthisbookhasbeenpresentedduringlecturesontheeconometrics
of energy markets and on commodity finance at the University Paris Dauphine. It
draws on feedback and practical exercises developed with former M.Sc. Students,
towhomthisbookislikewisededicated.
ThroughtheanalysisoftheEUETSandtheCDM,thebookshowshowtouse
a variety of econometric techniques to analyze an evolving and expanding carbon
marketsphereworldwide.Thebookoffersamixofknowledgeonemissionstrading
withpracticalapplicationstocarbonmarkets.Itcoversthestylizedfactsoncarbon
marketsfromaneconomicsperspective,aswellaskeyaspectsonpricingstrategies,
riskandportfoliomanagement.Ontheonehand,itcontainsusefulinformationon
how to interpret the historical development of the carbon price (until the present
time). On the other hand, it is instructive to teach students (advanced undergradu-
ates,M.Sc.,MBA)andresearchershowtousethesetechniquestoperformsimilar
exercisesascarbonmarketsevolveandexpand.Therefore,thesetechniquesmaybe
re-usedasnewnationalandregionalschemesappearinthenearfutureofenviron-
mentalregulation(China,USA,etc.).
Chapters1and2provideanaccessibleintroductiontothefundamentalsoftime
series econometrics to support anyone new to the material in learning the princi-
vii
viii Preface
plesofcarbonmarkets.StartinginChap.1withtheanalysisofdescriptivestatistics
forcarbonprices,theeconometricslearningprocessisregularthroughoutthebook.
Chapter1hasabroadcoverage,asthebookstartswiththereviewofinternational
climatepolicies (and thus of nationaland regionalcarbon markets initiativesas in
the US, Japan, China, Australia, etc.). In addition, it contains a brief introduction
tothemechanismofemissionstrading,andthemainfeaturesoftheEuropeancar-
bon market. It includes little econometric techniques (only a review of descriptive
statistics),butitcontainsnonethelessusefulbackgroundinformationforthebook.
Chapter2dealswithcarbonpricedrivers(mainlyinstitutionaldecisions,energy
pricesandextremeweatherevents)inthecontextofthelinearregressionmodel.It
covers perhaps the most interesting topic concerning CO prices, i.e. what are the
2
relevant price fundamentals on carbon markets? Starting with the use of dummy
variablesandtheBai-Perronstructuralbreaktest,itreliesheavilyonthelinearre-
gressionmodeltoshowtheinfluenceofotherenergyprices.Weathereventsareac-
countedforbyusingthresholdvariables(aboveorbelowagiventemperature).The
Appendix contains a useful review of the multivariate GARCH modelling frame-
workappliedtoenergyandCO prices.
2
Chapters 3 to 6 offer a smooth transition from being taught the basics in time
series econometrics to actively research carbon markets for term-papers or disser-
tations for advanced undergraduate and/or postgraduate students (M.Sc., MBA).
Chapter 3 deals with an equally important topic: what is the relationship between
thenewlycreatedemissionsallowancesandthepre-existingmacroeconomicenvi-
ronment?Thistopicistackledfirstbylookingatthelinkbetweentheequity/bond
markets and the emissions market in a GARCH modeling framework. Then, the
broadlinkswithmacroeconomic,financialandcommodityspheresarecapturedin
factor models. Next, the link with industrial production is studied by resorting to
nonlinearitytests,thresholdmodelsandMarkovregime-switching.
Chapter4focusesontheCleanDevelopmentMechanism,whichmaybeseenas
aproxyof‘world’carbonpricesintheabsenceofpost-Kyotoagreements.Besides
the description of the contracts, this chapter details the use of vector autoregres-
sion,Grangercausality,cointegrationtechniques(withtheEUcarbonprice)andthe
Zivot-Andrewsstructuralbreaktest.ArbitragestrategiesbetweentheEuropeanmar-
ketandtheCDMarestudiedinaGARCHmodelingframeworkwithmicrostructure
variablesinordertoexplaintheexistenceofthe‘EUA-CERspread’.TheAppendix
illustratestheuseoftheMarkovregime-switchingmodelswithEUAsandCERs.
Chapter5dealswithrisk-hedgingstrategiesandportfoliomanagement.Themain
riskfactorsrelatedtocarbonassetsaresummarized.Themeasureofriskpremiain
CO spot and futures prices is detailed based on commodity markets models and
2
linear regressions. Besides, carbon price risk management strategies are described
bythemeansofaneconometricanalysisofthefactorsinfluencingfuel-switchingin
thepowersector.Finally,portfoliomanagementtechniqueswithcarbonpricesare
explainedindetailswithstandardmean-varianceoptimizationtechniques.TheAp-
pendixrecallshowtouseoptionpricesforriskmanagementbycomputingimplied
volatilities.
Chapter 6 contains more advanced econometric techniques. It investigates
whetherornotthevolatilityofcarbonpricesshiftsasCO futurescontractsreach
2
Preface ix
maturity.Threeapproachesareusedasaproxyforvolatilityinordertoshedlight
on this issue: GARCH models, net cost-of-carry, and realized volatility. The so-
calledSamuelsonhypothesisistestedinaregressionframework,byaccountingfor
seasonalityandliquidityissues.TheAppendixcoversstatisticaltechniquesthatare
usefulinordertodetectinstabilityinthevolatilityofcarbonprices.
In order to replicate part of the empirical applications detailed in the vari-
ous chapters, this book recommends the use of the R software. R is a free soft-
waredesignedforstatisticalandeconometricanalysis.Itsinstallationisextremely
easy under any operating software, and comes with a documentation. The pack-
ages that are required to duplicate the results must be downloaded from the Com-
prehensive R Archive Network (CRAN) and pre-installed by the user with the
command install.packages() and by following the command prompt. Fi-
nally, the necessary data and R codes can be found on the author’s website:
http://sites.google.com/site/jpchevallier/publications/books/springer/.
This companion website with hyperlinks to data and computer codes related to
themodels,andthereplicationofexamplesdiscussedinthebook(whereitisrele-
vant)ensurethatthereaderisabletodevelophis/herprogrammingskills.Besides,
thisdatawarehousewithcomputercodesconstitutesanoriginalmeansofdissemi-
natingknowledge.TheinterestedreaderwillalsofindaFrequentlyAskedQuestions
(FAQ)sectiononthewebsite.
For developing R packages used in this book, I wish to thank Achim Zeileis,
Friedrich Leisch, Bruce Hansen, Kurt Hornik, Christian Kleiber, Patrick Brandt,
Bernhard Pfaff, Harald Schmidbauer, Angi Roesch, Vehbi Sinan Tunalioglu, Di-
ethelm Wuertz, Yohan Chalabi, Michal Miklovic, Chris Boudt, Pierre Chausse,
Douglas Bates, Ladislav Luksan, as well as the R core development team: http://
www.r-project.org/.
In terms of course use, this book may be appealing to courses in finance, such
asprinciplesoffinancialmarkets,financialeconomicsandfinancialeconometrics.
Itwillalsoberelevanttocoursesinenergy,environmentalandresourceeconomics,
asitcoverstheEUETSandtheKyotoProtocolwhichconstitutelandmarkenviron-
mental regulationpolicies.Since the carbon price constitutes a new commodity,it
willalsobeeligibletocoursesoncommoditymarketsandriskmanagementonthese
markets. Finally, empirical applications may be re-used in exercises for standard
(introductory) applied econometrics courses (such as time series analysis). Prob-
lem sets (with solutions manual) are presented at the end of the relevant chapters,
andpresentationslidesforeachchapterareavailableforinstructorsontheauthor’s
companionwebsite.
Last but not least, I wish to thank many people with whom I have been in-
teracting over the years, either in carbon finance or in academia, which led me
to develop the skills and material necessary to write this book: Emilie Alberola,
Benoit Cheze, Pascal Gastineau, Florian Ielpo, Maria Mansanet-Bataller, Morgan
Herve-Mignucci, Benoit Leguet, Anais Delbosc, Raphael Trotignon, Benoit Sevi,
YannickLePen,DerekBunn,ZongWeiLuo,ZhongXiangZhang,DennyEllerman,
OlivierGodard,KathelineSchubert,NatachaRaffin,PhilippeQuirion,DavidNew-
bery,FabienRoques,SamFankhauser,SimonDietz,EricNeumayer,LucaTaschini,
x Preface
IanLange,IbonGalarraga,MikelGonzalez,RalfAntes,BerndHansjurgens,Peter
Letmathe, Massimiliano Mazzanti, Anna Montini, Simon Buckle, Walter Distaso,
RobertKosowski,JanAhmerkamp,AndreasLoschel,DanielRittler,WaldemarRot-
fuss,EmericLujan,ErikDelarue,WilliamD’haeseleer,ValerieMignon,AnnaCreti,
Gilles Rotillon, Pierre-Andre Jouvet, Johanna Etner and Christian De Perthuis. At
theCGEMPoftheUniversityParisDauphine,Iwishtothankalltheteamandmore
particularlyJeanMarieChevalierandPatriceGeoffronwhohelpedmetofocuson
myresearch.
Paris,France JulienChevallier
Contents
1 IntroductiontoEmissionsTrading . . . . . . . . . . . . . . . . . . . 1
1.1 ReviewofInternationalClimatePolicies . . . . . . . . . . . . . . 1
1.1.1 FromRiotoDurban . . . . . . . . . . . . . . . . . . . . . 1
1.1.2 TheBurgeoningEUCO AllowanceTradingMarket . . . 3
2
1.2 MarketDesignIssues . . . . . . . . . . . . . . . . . . . . . . . . 4
1.2.1 InitialAllocationRules . . . . . . . . . . . . . . . . . . . 4
1.2.2 EquilibriumPermitsPrice . . . . . . . . . . . . . . . . . . 5
1.2.3 SpatialandTemporalLimits. . . . . . . . . . . . . . . . . 6
1.2.4 SafetyValve . . . . . . . . . . . . . . . . . . . . . . . . . 10
1.3 KeyFeaturesoftheEUEmissionsTradingScheme . . . . . . . . 10
1.3.1 ScopeandAllocation . . . . . . . . . . . . . . . . . . . . 10
1.3.2 Calendar . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
1.3.3 Penalties . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
1.3.4 MarketPlayers . . . . . . . . . . . . . . . . . . . . . . . . 12
1.4 EUAPriceDevelopment . . . . . . . . . . . . . . . . . . . . . . . 13
1.4.1 StructureandMainFeaturesofEUETSContracts . . . . . 13
1.4.2 CarbonPrice . . . . . . . . . . . . . . . . . . . . . . . . . 14
1.4.3 DescriptiveStatistics. . . . . . . . . . . . . . . . . . . . . 15
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
2 CO PriceFundamentals . . . . . . . . . . . . . . . . . . . . . . . . 19
2
2.1 InstitutionalDecisions . . . . . . . . . . . . . . . . . . . . . . . . 19
2.1.1 DummyVariables . . . . . . . . . . . . . . . . . . . . . . 19
2.1.2 StructuralBreaks . . . . . . . . . . . . . . . . . . . . . . 26
2.2 EnergyPrices . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
2.2.1 LiteratureReview . . . . . . . . . . . . . . . . . . . . . . 30
2.2.2 Oil,NaturalGasandCoal . . . . . . . . . . . . . . . . . . 31
2.2.3 ElectricityVariables . . . . . . . . . . . . . . . . . . . . . 35
2.3 ExtremeWeatherEvents . . . . . . . . . . . . . . . . . . . . . . . 40
2.3.1 RelationshipBetweenTemperaturesandCarbonPrices . . 41
2.3.2 EmpiricalApplication . . . . . . . . . . . . . . . . . . . . 43
xi
xii Contents
Appendix BEKKMGARCHModelingwithCO andEnergyPrices . 45
2
Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
3 LinkwiththeMacroeconomy . . . . . . . . . . . . . . . . . . . . . . 55
3.1 StockandBondsMarkets . . . . . . . . . . . . . . . . . . . . . . 55
3.1.1 GARCHModelingoftheCarbonPrice . . . . . . . . . . . 55
3.1.2 RelationshipwithStockandBondMarkets . . . . . . . . . 60
3.2 Macroeconomic,FinancialandCommodityIndicators . . . . . . . 66
3.2.1 ExtractingFactorsBasedonPrincipalComponentAnalysis 67
3.2.2 Factor-AugmentedVARAnalysisAppliedtoEUAs . . . . 68
3.3 IndustrialProduction. . . . . . . . . . . . . . . . . . . . . . . . . 71
3.3.1 Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
3.3.2 NonlinearityTests . . . . . . . . . . . . . . . . . . . . . . 74
3.3.3 Self-excitingThresholdAutoregressiveModels . . . . . . 78
3.3.4 ComparingSmoothTransitionandMarkov-Switching
AutoregressiveModels . . . . . . . . . . . . . . . . . . . 87
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
4 TheCleanDevelopmentMechanism . . . . . . . . . . . . . . . . . . 105
4.1 CERsContractsandPriceDevelopment . . . . . . . . . . . . . . 105
4.2 RelationshipwithEUEmissionsAllowances . . . . . . . . . . . . 107
4.2.1 VARAnalysis . . . . . . . . . . . . . . . . . . . . . . . . 107
4.2.2 Cointegration . . . . . . . . . . . . . . . . . . . . . . . . 117
4.3 CERsPriceDrivers . . . . . . . . . . . . . . . . . . . . . . . . . 123
4.3.1 Zivot-AndrewsStructuralBreakTest . . . . . . . . . . . . 124
4.3.2 RegressionAnalysis . . . . . . . . . . . . . . . . . . . . . 126
4.4 ArbitrageStrategies:TheCER-EUASpread . . . . . . . . . . . . 131
4.4.1 WhySoMuchInterestinThisSpread? . . . . . . . . . . . 131
4.4.2 SpreadDrivers . . . . . . . . . . . . . . . . . . . . . . . . 132
Appendix MarkovRegime-SwitchingModelingwithEUAsandCERs 133
Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
5 Risk-HedgingStrategiesandPortfolioManagement . . . . . . . . . 147
5.1 RiskFactors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147
5.1.1 IdiosyncraticRisks. . . . . . . . . . . . . . . . . . . . . . 148
5.1.2 CommonRiskFactors . . . . . . . . . . . . . . . . . . . . 149
5.2 RiskPremia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151
5.2.1 TheoryonSpot-FuturesRelationshipsinCommodity
Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . 151
5.2.2 Bessembinder and Lemmon’s (2002) Futures-Spot
StructuralModel . . . . . . . . . . . . . . . . . . . . . . . 153
5.2.3 EmpiricalApplication . . . . . . . . . . . . . . . . . . . . 154
5.3 ManagingCarbonPriceRiskinthePowerSector. . . . . . . . . . 157
5.3.1 EconomicRationale . . . . . . . . . . . . . . . . . . . . . 157
5.3.2 UKPowerSector . . . . . . . . . . . . . . . . . . . . . . 158
