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Reshaping the EU Emission Trading Scheme: an econometric assessment

The EU has substantially reformed the EU ETS in its third trading period. A single European emissions cap has been applied, free allocation of certificates has been replaced by auctions and, most prominently, “backloading” was introduced at the beginning of this year: the auctioning of a total of 900 million allowances is postponed until 2019/2020. The political aim of these institutional changes was to stabilize demand and prices of certificates. Although the issue is of great importance, literature on how well these reforms improved the performance of the EU ETS is scarce. Therefore, we empirically estimate whether the recent EU ETS reforms have increased the efficiency of the EU ETS interpreted as an emission certificate price that is more driven by abatement cost related market fundamentals after the reforms.

The European Emission Trading System (EU ETS) is the most important EU-wide policy instrument to incentivize firms to emit less carbon. The objective of the EU ETS is (1) to restrict carbon emission to a certain amount within a given time period (the so called trading period) and (2) to do this in an economically efficient way i.e. at minimal cost. A related third objective of the EU ETS is to (3) incentivize efficient emissions reductions not only in the currently but also in the long run.

These objectives are to be reached by the following market design: a certain amount of emission certificates - called European Emission Allowances (EUA) each worth a one ton of carbon - is allocated to the economic agents. In order to decrease overall emissions, the total number of EUA - the so called emissions cap - should be lower than the number of allowances companies would need in a business-as-usual scenario. At the end of each trading period firms have to cover all their emissions with emission allowances or get sanctioned. In order to use the allowances in the economy where they are most valuable i.e. where abating emissions is costliest, the EU ETS allows firms to trade certificates. Firms with relatively high abatement costs will buy certificates whereas firms with relatively low abatement costs will sell certificates.

Hence, we intend to empirically investigate whether the market design that was introduced in the third trading period as well as the adjustments during the third trading period have lead EUA prices to follow the fundamental drivers more closely and, hence, led to a more efficient EU ETS mechanism. The analysis includes specifying and estimating an empirical model that explains the EUA price by its fundamental drivers. In order to investigate whether the reforms have improved the efficiency of the EU ETS market design, we, first, test for structural breaks in the parameters that describe the relationship between the EUA price and its fundamental drivers and, second, assess whether the set of fundamental drivers has gained explanatory power for the EUA prices after a market design change happened. Furthermore, shocks in EUA prices might have an influence on the prices of “fundamentals” such as coal and gas prices. Hence, we need to take account of potential endogeneity of some drivers of the EUA prices - something which was ignored in many earlier studies which mostly used single equation approaches.

Our results will improve our understanding of whether and which of the significant EU ETS design changes that came with the third trading period improved the efficiency of the EU ETS. Hence, we will provide valuable insights for further improvements of the EU ETS market design in the fourth trading period starting in the year 2021.


Prof. Dr. Jörg Breitung (Institute of Econometrics and Statistics)

Prof. Dr. Dieter Hess (Business Administration and Corporate Finance)