We provide the first evidence on catalysts for price discovery in the European Union Emissions Trading System. Specifically, by employing high frequency data across a wide range of fungible securities, we find that trading costs are a more important determinant of price discovery than either the implicit provision of leverage in securities such as futures and options or the existence of market segmentation. Moreover, securities with low trading costs display greater price discovery than those with high trading costs.
The European Union Emissions Trading System (EU ETS) is a decentralised market place encompassing over-the-counter (OTC) trading of emission allowances as well as spot, futures and options trading on organised exchanges. With such a wide dispersion of tradable securities and trading venues, understanding both the source of, and catalysts for, price discovery is of crucial importance to regulators, practitioners and academics alike. A number of studies explore price discovery in Phase I of the scheme (see, for example, Uhrig-Homburg and Wagner, 2009 and Benz and Hengelbrock, 2008), where an oversupply of allowances late in the phase saw prices collapse, as well as in the scheme’s better functioning Phase II (see, for example, Chevallier, 2010a, Chevallier, 2010b, Mizrach, 2012 and Cummins, 2012).1 However, most of this work employs daily data to gauge the location of price discovery and, in doing so, obscures the important, granular aspects of the timeliness of price responses to information arrival. Moreover, studies that do perform intraday analysis (see, for example, Mizrach and Otsubo, 2011 and Rittler, 2012) undertake a binary comparison of specific securities and do not consider which frictions drive the price discovery process in the market overall.
Against this backdrop, we contribute to the literature by employing high frequency data to fully characterise both the location and determinants of short- and long-run price discovery in Phase II of the EU ETS. Specifically, we first assess contemporaneity of returns using a regression approach similar to that of Fleming et al. (1996) and examine the contribution of each security to the long-term price equilibrium using Hasbrouck’s (1995) information shares. Thereafter, we consider the identity and effect of market frictions on price discovery. If two securities are perfect substitutes for one another, or are identically affected by the same information, their prices should change simultaneously in a frictionless market. That is, neither security should display greater price discovery than the other. Similarly, given minimal short-term changes in carrying costs, the prices of derivative securities should simultaneously change to reflect information regarding the value of underlying assets. However, as discussed previously, despite EU ETS instruments being essentially fungible with one another, evidence suggests they do not impound new information simultaneously and, thus, that traders may have preferences for particular securities. This, in turn, suggests frictions exist within the market that impede price discovery. We study the effect of three specific frictions on this process, namely trading costs, leverage and market segmentation. Indeed, the large number of equivalent securities in the EU ETS provides an ideal opportunity to quantify the impact of market frictions on price discovery more generally.
The remainder of this paper is structured as follows: Section 2 discusses the development and structure of the EU ETS; Section 3 identifies potential catalysts for price discovery in these emissions trading markets; Section 4 discusses the methodology employed in testing avenues of price discovery; Section 5 discusses the data employed in testing; Sections 6 and 7 overview the results of our central and robustness testing, respectively; and, Section 8 concludes.
We employ high frequency data collected in respect of multiple securities to more fully characterise price discovery within the EU ETS and provide the first evidence on catalysts thereof. More specifically, we consider the importance of trading costs, leverage and market segmentation in affecting both short-run return dynamics as well as securities’ contribution to long-run price equilibrium in this market. Understanding both the location, and driving factors, of price discovery is critical for all market participants given its importance in ensuring the efficient allocation of capital in these markets.
Our testing confirms existing evidence (Rittler, 2012) regarding the ICE EUA futures contract as the primary source of price discovery in both the short- and long-term. We also demonstrate the relative importance of both major European Allowance spot markets in this regard. Surprisingly, testing also suggests that, despite its low trading volume and uncertainties surrounding the use of project-based allowances, futures contracts over these credits also make a material contribution to price discovery. Subsequent analysis reveals that trading costs are the primary catalyst for price discovery in both the short- and long-term, with lower (higher) trading cost securities exhibiting faster (slower) adjustment to new information. In contrast, leverage and market segmentation appear to be relatively unimportant drivers of price discovery in the EU ETS. These results are robust to changes in intraday sampling frequency and the use of an alternate price and return metric. Overall, our findings are also consistent with price discovery studies undertaken in other contexts, including equity markets (Fleming et al., 1996, Booth et al., 1999 and Hsieh et al., 2008).
