The relationship between spot and futures CO2 emission allowance prices in the EU-ETS

In this paper we investigate the relationship between spot and futures prices within the EU-wide CO2 emissions trading scheme (EU-ETS). We conduct an empirical study on price behavior, volatility term structure and correlations in different CO2 EU Allowance (EUA) contracts during the pilot trading and Kyoto commitment periods. We find that while for the pilot trading period (2005-2007) the market was initially in backwardation, after the news of overallocation, both allowance prices and convenience yield approached zero. During the Kyoto commitment period (2008-2012), the market has changed from initial backwardation to contango with significant convenience yields in futures contracts. We further examine the dynamic structure of the relationship between spot and futures prices in the functional form by applying a new approach of dynamic semiparametric factor models (DSFM). Interestingly, our DSFM results can be related to the classic Gibson-Schwartz two-factor model for pricing contingent claims in commodity markets that uses the spot price and the instantaneous convenience yield as factors. Our results might point towards future applications of the Gibson-Schwartz model for pricing of intra- and inter-period EUA derivatives contracts.