Dynamic Price Linkage and Volatility Structure between Carbon Markets

This paper investigates the dynamic price linkage and volatility structure between two leading carbon markets of EU allowance (EUA) and secondary certified emission reduction (sCER). We propose a correlation model between EUA and sCER price returns using the marginal abatement cost (MAC) curve and the emission reduction volume. The model reflects two hold market observations: the financial players' EUA-sCER swap transaction in carbon price boom periods and stronger energy price impacts on EUA prices than sCER prices. The model demonstrates that the volatilities are affected by the MAC curve shape and the emission reduction volume while the correlations are indifferent from the MAC curve shape and affected by the emission reduction behavior. The model also suggests that the EUA-sCER price correlations increase when the swap transaction increases or energy prices fall, translated into the opposite EUA price movements of EUA price rise or fall, respectively. Then we offer an example of the model using an inverse Box-Cox function MAC curve with a positive parameter where the volatility in carbon prices decreases in the prices referred to as “leverage effect” often observed in security markets. The empirical studies using EUA and sCER prices estimate the model parameters, resulting in the positive EUA volume impact on EUA-sCER swap transactions and the positive energy price impact on EUA prices. It is shown that the high EUA-sCER correlations in high EUA prices stem from the EUA-sCER swap transaction while the high correlations during financial turmoil period with low EUA prices come from energy price drop. We also show that the leverage effects often observed in security markets exist in both EUA and sCER markets according to the price-volatility relationship. Additionally, the empirical studies using Engle's dynamic conditional correlation model demonstrate higher EUA-sCER price correlations in higher or lower EUA prices, which are consistent with the parameter estimation results of the proposed model. Moreover it is shown using the DCC model that EUA prices are more strongly affected by oil prices than sCER prices, which offers a supportive evidence of the model assumption