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In this paper, we study the relationship between futures and spot prices in the European carbon markets from the cost-of-carry hypothesis. The aim is to investigate the extent of efficiency market. The three main European markets (BlueNext, EEX and ECX) are analyzed during Phase II, covering the period from March 13, 2009 to January, 17, 2012. Futures contracts are found to be cointegrated with spot prices and interest rates for several maturities in the three CO2 markets. Results are similar when structural breaks are taken into account. According to individual and joint tests, the cost-of-carry model is rejected for all maturities and CO2 markets, implying that neither contract is priced according to the cost-of-carry model. The absence of the cost-of-carry relationship can be interpreted as an indicator of market inefficiency and may bring arbitrage opportunities in the CO2 market.

The European Union Emission Trading Scheme (EU ETS) went into effect on January 2005, considering the EU Directive 2003/87/EC. The EU ETS is one of the most important initiatives taken to reduce the greenhouse gas (GHG) emissions (primarily CO2) that cause climate change (Kyoto protocol). The inclusion of the aviation sector from 1st January 2012 onwards represents a new step in the implementation of the EU ETS.1 Following the steady expansion of the EU ETS' scope to new Member States since 2005, the European Commission is now adding around 5000 European airline companies and foreign companies that do business in Europe to the 11 500 industrial and manufacturing participating installations. In 2010, it is estimated that the sources to which the trading scheme applies account for 45% of CO2 emissions and a little less than 40% of total GHG emissions in that year. The EU ETS introduces a cap-and-trade system, which operates through the creation and distribution of tradable rights to emit, usually called EU allowances (EUAs)2 to installations. Since a constraining cap creates a scarcity rent, these EUAs have value. The distribution of these rights for free is called free allocation and is the unique feature of this cap-and-trade system. The cap-and-trade scheme operates over discrete periods, with the first or pilot period (Phase I, 2005–2007) and with the second period corresponding to the first commitment period of the Kyoto Protocol. This period extends from 2008 to 2012 (Phase II) and will be followed by a third period from 2013 to 2020 (Phase III). Phase II represents the fundamental regulatory tool allowing Member States to reach their Kyoto target. The EU target is a reduction of 8% below 1990 emissions in the 2008–2012 period.3 To help countries in achieving their reduction objectives, the Protocol includes three flexibility mechanisms: The creation of an International Emission Trading, Joint Implementation and the Clean Development Mechanism.4 The EU ETS includes spot, futures, and option markets with a total market value of View the MathML source€72billion in 2010. Futures contracts account for a wide part of this value (about 87% in 2010). Understanding the relationship between spot and futures prices is thus of crucial importance for all participants in the carbon market. Carbon trading works only if markets for carbon provide enough liquidity and pricing accuracy, i.e. markets provide prices that are useful for hedgers and other users of carbon markets. The efficiency of the CO2 market is particularly important for emission intensive firms, policy makers, risk managers and for investors in the emerging class of energy and carbon hedge funds (see Krishnamurti and Hoque, 2011). Although relevant papers have been published on the behavior of emission allowance spot and futures prices (see, e.g., Alberola et al., 2008, Daskalakis and Markellos, 2008, Paolella and Taschini, 2008 and Seifert et al., 2008; Benz and Trück, 2009), studies on CO2 market efficiency between futures and spot prices are rather sparse (Daskalakis et al., 2009, Uhrig-Homburg and Wagner, 2009 and Joyeux and Milunovich, 2010). These studies examine the extent of market efficiency in the CO2 futures market by conducting empirical tests of the cost-of-carry model, which allow us to ascertain the degree to which carbon futures prices reflect their theoretical (no arbitrage) values. This approach is especially useful in the context of examining whether futures contracts are efficiently priced with respect to the underlying emission rights allowances. If these contracts are efficiently priced then participating countries and covered installations in them can achieve environmental compliance in a cost-effective and optimal manner (Krishnamurti and Hoque, 2011). The aim of this paper is to investigate the efficiency hypothesis between spot and futures prices negotiated on European markets from a cost-of-carry model, by extending the previous studies in three ways: (i) we study the three main European markets, BlueNext, European Energy Exchange (EEX), and European Climate Exchange (ECX); (ii) we consider the second trading period (Phase II) from March 13, 2009 to January 17, 2012; and (iii) we test the cost-of-carry model using four futures contracts (December 2009, December 2010, December 2011 and December 2012 maturities). This study should give a more complete picture of the relationships between spot and futures prices in the EU ETS. We apply the cointegration methodology developed by Johansen, 1988 and Johansen, 1991 to test for multivariate cointegration between the series (futures prices, spot prices and interest rate) before estimating the cost-of-carry relationship. Indeed, the theoretical connection between spot and futures prices is a long-run, rather than short-run, concept. In the short-run, there might be deviations between spot prices and futures prices that can be induced by, for example, thin trading or lags in information transmission (Maslyuk and Smyth, 2009). The visual inspection of the data in Fig. 1, Fig. 2 and Fig. 3 reveals a sharp price break for spot and futures price series of all maturities in the three markets in June 2011.5 This fall of 20% followed the announcement of the EU's upcoming “energy efficiency directive,” presented on 22nd of June 2011, proposing a new contract with member states for cutting energy consumption in buildings, vehicles and more controversially, industry. Therefore, we also use the approach suggested by Johansen et al. (2000) to take into account the presence of structural breaks.6

Understanding the relationship between spot and futures prices is thus of crucial importance for all participants in the carbon market. Carbon trading works only if markets for carbon provide enough liquidity and pricing accuracy, i.e. markets provide prices that are useful for hedgers and other users of carbon markets. The efficiency of the CO2 market is particularly important for emission intensive firms, policy makers, risk managers and for investors in the emerging class of energy and carbon hedge funds. Newberry (1992) suggests that futures markets provide opportunities for market manipulation. According to this view, the futures market can be manipulated either by the better informed at the expense of the less informed or by the larger at the expense of the smaller (Maslyuk and Smyth, 2009). If carbon markets are inefficient the policy implications are that there is a greater role for regulation to improve information flows and reduce market manipulation (Stout, 1995). It is imperative that policy makers address these issues during the eminent reviewing process, to ensure that the EU ETS evolves into a mature, efficient and internationally competitive market. Recently, Krishnamurti and Hoque (2011) suggest four propositions to improve the efficiency of the CO2 markets: (i) emission permits should not be freely allocated; (ii) intertemporal use of permits should be allowed; (iii) international linkage and trading of permits must be fully explored; and (iv) an independent administrator must be set up to administer all issues pertaining to emissions allocation and trading. We modeled the relationship between futures and spot prices in the European carbon markets from the cost-of-carry hypothesis to investigate the extent of efficiency market. We studied the three main European markets (BlueNext, EEX and ECX), and four futures contracts (December 2009, December 2010, December 2011, and December 2012) during Phase II, covering the period from March 13, 2009 to January 17, 2012. We found that futures contracts, whatever the maturity, were cointegrated with spot prices and interest rates for the three CO2 markets from cointegration tests with and without structural breaks. According to individual and joint tests, the cost-of-carry model was rejected for all maturities and CO2 markets, implying that neither contract was priced according to the cost-of-carry model. The absence of the cost-of-carry relationship can be interpreted as an indicator of market inefficiency and may bring arbitrage opportunities in the CO2 market. If the cost of carry model is not observed, arbitrage opportunities can happened. An investor can benefit from an arbitrage opportunity when the cost of buying the right of carbon emission, is lower than the price at which the said emission can be sold in the future, and where such sale price can be locked-in by the investor by means of selling a futures contract. On the specified date in the futures contract, the investor will deliver the physical or financial asset and crystallize the arbitrage profit. Thanks to arbitrage, all prices for a given asset are equal at a given point in time. Arbitrage ensures fluidity between markets and contributes to their liquidity. It is the basic behavior that guarantees the efficient market (Vernimmen, 2011).