An Empirical Examination of the EUA Emission Rights Market: Investigation of the price dynamics of EUA future contracts

Abstract: Since the introduction of an international market for emission rights researchers are still trying to determine the price dynamics of these instruments, which are traded in a market that bears no resemblance to any other equity or commodity market to date. In our thesis we apply econometric analysis and derivative theory to find factors that affect the prices of EUA futures. We use regression analysis and ARIMA modeling, combined with ARCH and GARCH modeling for error term variance. Although we find that major equities and interest rates are weakly correlated with EUA returns, we can establish that when modeling EUA future returns with a threshold GARCH process we obtain significantly better results than previous studies. Since the sample period is largely affected by extreme observations during the initial trading period we also broke the sample down into sub-periods and repeated the tests. Our findings suggest that while the initial sub-period shows significant autoregressive behavior, the latter period follows a random walk. We also determine whether the standard cost of carry approach can be applied to link EUA spot and future prices. We find that there are significant convenience yields in the EUA market for the first sub-period, while the second shows no significant convenience yields. We finally conduct ARIMA modeling and test for convenience yield for the first half of 2008. Our results indicate that there is a positive convenience yield of holding future contracts and the autoregressive behavior has diminished, signifying that the market follows a random walk.