Pricing Carbon: Allowance Price Determination in the EU ETS

The allowance price in Phase I of the European Union Emissions Trading Scheme (EU ETS) followed a peculiar path, increasing from €7 in 2005 to over €30 in 2006, before crashing, recovering and ultimately finishing at zero by the end of 2007. I examine if the price can be explained by marginal abatement costs as predicted by economic theory, or if there were other price determinants. This has important policy implications, since the least-cost solution depends on the equality of permit price and marginal abatement costs and is the main argument in favor of permit markets. I start with a model that incorporates the most commonly cited market fundamentals and find that the latter only explain a small part of the allowance price variation, raising the question of a bubble. I carry out two different bubbles tests, the results of both of which are consistent with the presence of an allowance price bubble. I then address whether market manipulation by dominant power generators could have lead to the initial allowance price increase. I extend economic theory to include the interaction between output and permit markets. I derive a threshold of free allocation beyond which firms find it profitable to manipulate the permit price upwards, even if they are net allowance buyers. Market data indicates that this threshold was exceeded for EU power generators. Finally, I investigate the possibility that due to the speed at which the market was set up, firms may have been unable to engage in effective abatement before the end of Phase I. I develop a model under the assumption of no abatement, where firms aim to reach compliance exclusively by purchasing allowances on the market. Thus, the allowance payoff becomes that of a binary option, for which I derive a pricing formula. The model fits daily data from the years 2006-7 well. I conclude that the allowance price in Phase I was not driven by marginal abatement costs, but by a combination of price manipulation, self-fulfilling expectations and/or the penalty for noncompliance weighted by the probability of a binding cap.