Exploring the Impact of COVID-19 on the European Union Emission Trading Scheme
In this article, co-authors Abhinava Tripathi, Charu Vadhava, and Ravi Raushan Jha reflect on the inspiration behind their research article, “Pricing efficiency of European carbon futures market during the COVID-19 pandemic,” published in the Australian Journal of Management.
Over the past few decades, climate change has been one of the most severe global issues on the table of international authorities and governments across the globe. Globally, carbon emissions from energy consumption and industrial activity have reached an all-time high of 36.8 Gigatonnes (Gt). Such alarming environmental changes pose significant risks not only to global businesses and corporations but also to socioeconomic well-being and overall human capital development across the world. Consequently, global authorities and governments have shifted their attention toward policies that can reduce Greenhouse gas (GHG) emissions and decelerate the pace of climate change.
To this end, the European Union Emission Trading Scheme (“EU-ETS”), the most prominent emission trading scheme, was implemented in 2005. The ultimate objective of the scheme is to drive investments towards energy-efficient and clean technologies. The success of any such carbon trading scheme lies in its ability to anchor carbon pricing with economic activity and, in turn, the emission levels by covered installations. The continuous development of EU-ETS in size, liquidity, and trading volume has garnered significant interest from academics, policymakers, investors, and risk managers, and it has instigated researchers to undertake studies on the pricing mechanisms in EU-ETS.
The impact of the crisis on financial markets has been the subject of many important studies. The literature documents that the onset of crisis events has significant implications on financial markets, including falling prices, high volatility levels, low levels of informational efficiency, and poor market quality. In this backdrop, the global economic recession caused by the Covid-19 pandemic was extraordinarily severe. Given the severe implications of the Covid-19 pandemic, it is expected to have significant repercussions not only for the conventional financial markets but also for carbon markets such as the EU-ETS.
Our study addresses some crucial questions. First, how efficient is the European carbon market, and does it remain efficient during the crises? Second, how closely is the European carbon market linked to the level of economic activity in European markets, and does it remain intact with the level of economic activity during the crises? To address these questions, we examine the level of market efficiency of EU-ETS during the pandemic. Next, we also examine the relationship of EU-ETS with the economic activity in the five important markets in Europe and the U.K.
Our results reveal that the European carbon market is weak-form efficient at 5- and 30-minutes. It is worth highlighting that the pricing efficiency of EU-ETS remains intact even when the effect of the Covid-19 pandemic is most severe, attaining maturity levels comparable to conventional financial markets. Next, we show that the pricing in the carbon market reflects the economic activity even at short horizons such as 5- and 30-minutes, which is an important stated objective of the EU-ETS. Moreover, our DCC-GARCH results show that the European carbon prices are well anchored to the index prices, and these linkages do not break even during the Covid-19 pandemic outbreak.
