Emission Trading in a High Dimensional Context: To What Extent Carbon Markets are Integrated with the Broader System?

Abstract

The following work will provide further insights into the influence of European Emission Allowance (EUA) prices on carbon dioxide trends and relevant variables of the economic-financial climate-environmental system considering a large set of time series. The methodological approach will employ Hierarchical Vector Autoregression by W. B. Nicholson et al. (2020) deal with a high-dimensional context. Results of the two specifications highlighted how CO2 appears to be more influenced by commodity prices, climate variables, along with past industrial performances. Furthermore, a shock of carbon prices could potentially exert significant turbulence on the carbon dioxide series, fading in intensity as time goes by. Overall, despite some instances (e.g., CO2), there appears to be a straightforward (negative) effect on the influence of carbon prices on the system. However, further analyses identified how the external contribution to the variance appears to be quite limited for the variable of interest (i.e., carbon price) and the others. As the cornerstone of the EU climate policy, this work sheds light on the influence the EU ETS exerts on a set of multidimensional variables, considering the possible sources of shocks and implementing adjustment mechanisms for EUA prices.