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ECONOMIC ANALYSES OF WORLD’S CARBON MARKETS By Tajinder Pal Singh Bhatia A thesis submitted in conformity with the requirements for the degree of Doctor of Philosophy Faculty of Forestry and Centre for Environment University of Toronto © Copyright by Tajinder Pal Singh Bhatia 2012

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Page 1: ECONOMIC ANALYSES OF WORLD’S CARBON MARKETS · world’s markets are expected to be limited, and carbon trading in these markets will be globally inefficient. There is a strong

ECONOMIC ANALYSES OF WORLD’S CARBON MARKETS

By

Tajinder Pal Singh Bhatia

A thesis submitted in conformity with the requirements for the degree of Doctor of Philosophy

Faculty of Forestry and Centre for Environment University of Toronto

© Copyright by Tajinder Pal Singh Bhatia 2012

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ECONOMIC ANALYSES OF WORLD’S CARBON MARKETS

Tajinder Pal Singh Bhatia

Doctor of Philosophy

Faculty of Forestry and Centre for Environment University of Toronto

2012

Abstract

Forestry activities play a crucial role in climate change mitigation. To make carbon credits

generated from such activities a tradable commodity, it is important to analyze the price

dynamics of carbon markets. This dissertation contains three essays that examine various issues

confronting world’s carbon markets.

The first essay investigates cointegration of carbon markets using Johansen maximum likelihood

procedure. All carbon markets of the world are not integrated. North American carbon markets

show integration and so do the CDM markets. For future, the possibilities of arbitrage across

world’s markets are expected to be limited, and carbon trading in these markets will be globally

inefficient. There is a strong need of a global agreement that allows carbon trade to prevent

climate change at the least cost options.

The second essay evaluates various econometric models for predicting price volatility in the

carbon markets. Voluntary carbon market of Chicago is relatively more volatile; and like other

financial markets, its volatility is forecasted best by a complex non-linear GARCH model. The

compliance market of Europe, on the other hand, is less volatile and its volatility is forecasted

best by simple econometric models like Historical Averages and GARCH and hence is different

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from other markets. Findings could be useful for investment decision making, and for making

choice between various policy instruments.

The last essay focuses on agent based models that incorporate interactions of heterogeneous

entities. Artificial carbon markets obtained from such models have statistical properties - lack of

autocorrelations, volatility clustering, heavy tails, conditional heavy tails, and non-Gaussianity;

which are similar to the actual carbon markets. These models possess considerably higher

forecasting capabilities than the traditional econometric models. Forecast accuracy is further

improved considerably through experimentation, when agent characteristics like wealth

distribution, proportion of allowances and number of agents are set close to the real market

situations.

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Acknowledgments

The completion of this research would not have been possible without the guidance, suggestions,

inspiration, support and love of many individuals.

First, I am greatly indebted to and would like to express my heartfelt appreciation to my

supervisor, Prof Shashi Kant for his valuable guidance, incessant encouragement and consistent

support throughout the course of this research. I thank him for involving me in this endeavor and

having confidence in my abilities to handle such a new and intricate research topic. The

discussions with him really broadened my knowledge and understanding of topic and equipped

me with necessary skills to carry out this task. This in fact had greatly improved the quality of

essays in dissertation. Without his critical reviews and intellectual inputs, this dissertation would

not have been possible in its present form. I am also indebted to the other members of my

research committee, namely Dr. Jagdish Nautiyal, Dr. David Nanang, Prof Martin Burda and Dr

Wang Sen for their valuable contribution and sparing time out of their busy schedule.

I am grateful for the academic and administrative support from the faculty members at the

Faculty of Forestry, the Centre for Environment and the Department of Economics. I would also

like to extend my gratitude to all the friends that I have made during the course of my research.

Financial support from the Nozzolillo Fellowship, Dixon Fellowship and Buckley Graduate

Scholarships at the University of Toronto is highly acknowledged. My sincere thanks are also

due to my employer, Forest Department, Government of Haryana, India for their supportive role

in sparing my services and sanctioning me study-leave to carry out this task.

I am highly grateful to my parents, Shri Ajit Singh Bhatia and Late Mrs. Manjit Kaur, for

inculcating the values of hard work and perseverance in me. Their deepest love and care have

shaped me to become an optimistic person and have helped me to remain positive and cheerful

even in times of overwhelming stress. My deep gratitude goes to my wife, Alakjot, for her

sacrifices, unconditional love and for all the support that she has given me during the past few

years. She endured all the pains so that I could accomplish my goal. It is truly a gift to have a son

like Anmol, who grows more precious with the years and has always been an overwhelming

source of joy- and for that I am very thankful. Last but not the least, I wish to thank God for

giving me such a wonderful environment that made my research possible.

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Table of Contents

Acknowledgments .......................................................................................................................... iv

Table of Contents ............................................................................................................................ v

List of Tables................................................................................................................................... x

List of Figures ...............................................................................................................................xii

List of Appendices ....................................................................................................................... xiv

1 Introduction ................................................................................................................................ 1

1.1 Climate Change and Carbon Emissions .............................................................................. 1

1.2 Role of forests in carbon emissions and sequestration........................................................ 1

1.3 Role of carbon markets in forest investment decisions....................................................... 2

1.4 Literature Review................................................................................................................ 3

1.5 Organization of thesis.......................................................................................................... 7

2 Overview of World’s Carbon Markets ....................................................................................... 9

2.1 Carbon Trading ................................................................................................................... 9

2.2 Economic theory behind carbon markets ............................................................................ 9

2.3 Types of carbon markets ................................................................................................... 10

2.3.1 Compliance Markets ............................................................................................. 10

2.3.2 Voluntary markets ................................................................................................. 10

2.4 Existing carbon markets .................................................................................................... 11

2.4.1 EU Emissions Trading Scheme............................................................................. 11

2.4.2 Clean Development Mechanism (CDM)............................................................... 11

2.4.3 Carbon Markets in the USA.................................................................................. 12

2.4.4 Canadian Carbon Market ...................................................................................... 13

3 A cointegration analysis of Carbon Prices in EU and North America ..................................... 15

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3.1 Introduction ....................................................................................................................... 15

3.2 Theoretical concepts.......................................................................................................... 20

3.2.1 Cointegration......................................................................................................... 20

3.2.2 Testing for Stationarity and Structural Breaks in time-series ............................... 22

3.2.3 Lag length in the VEC Model ............................................................................... 23

3.2.4 Testing for Parameter Stability ............................................................................. 23

3.3 Data Description................................................................................................................ 24

3.3.1 European Climate Exchange (ECX) ..................................................................... 24

3.3.2 Chicago Climate Exchange (CCX) ....................................................................... 24

3.3.3 Regional Greenhouse Gas Initiative (RGGI) ........................................................ 25

3.3.4 California Climate Action Registry (CCAR) ........................................................ 25

3.3.5 Montréal Climate Exchange (MCeX) ................................................................... 25

3.4 Results and Discussion...................................................................................................... 27

3.4.1 Results for Unit Root Tests ................................................................................... 27

3.4.2 Carbon Market Integration at international level .................................................. 29

3.4.3 Long-run relationships of prices ........................................................................... 35

3.5 Summary and Conclusions................................................................................................ 37

4 Forecasting volatility of carbon markets .................................................................................. 41

4.1 Introduction ....................................................................................................................... 41

4.2 Volatility in carbon markets.............................................................................................. 45

4.3 Econometric Models used to test Volatility ...................................................................... 46

4.3.1 Random Walk........................................................................................................ 46

4.3.2 Historical average.................................................................................................. 46

4.3.3 Moving averages ................................................................................................... 46

4.3.4 OLS regression...................................................................................................... 46

4.3.5 Autoregressive conditional heteroskedasticity (ARCH) ....................................... 47

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4.3.6 Generalized autoregressive conditional heteroskedasticity (GARCH)................. 47

4.3.7 Asymmetric GARCH ............................................................................................ 48

4.3.8 Non-linear GARCH............................................................................................... 48

4.4 Testing for Stationarity and Structural Breaks .................................................................. 49

4.5 Evaluation Measures ......................................................................................................... 50

4.5.1 Root mean square error (RMSE)........................................................................... 50

4.5.2 Theil-U statistic ..................................................................................................... 50

4.5.3 LINEX loss function ............................................................................................. 50

4.6 Data ................................................................................................................................... 51

4.7 Results ............................................................................................................................... 51

4.7.1 Graphical analysis ................................................................................................. 52

4.7.2 Stationarity analysis .............................................................................................. 53

4.7.3 Volatility analysis.................................................................................................. 55

4.8 Summary and conclusions................................................................................................. 60

5 An Agent-Based Model of Carbon Markets............................................................................. 64

5.1 Introduction ....................................................................................................................... 64

5.2 Theoretical Framework ..................................................................................................... 67

5.2.1 Model of agents ..................................................................................................... 68

5.2.2 Model of price determination................................................................................ 69

5.2.3 Trading rules and expectation formations ............................................................. 71

5.2.4 Learning ................................................................................................................ 72

5.3 Adaptive Modeler- The Software Platform....................................................................... 73

5.4 Model Parameters.............................................................................................................. 74

5.4.1 Population Size...................................................................................................... 74

5.4.2 Wealth distribution................................................................................................ 74

5.4.3 Position distribution .............................................................................................. 75

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5.4.4 Basis of forecast .................................................................................................... 75

5.4.5 Trading rules ......................................................................................................... 75

5.4.6 Breeding ................................................................................................................ 76

5.5 Statistical Properties of Carbon Markets........................................................................... 76

5.5.1 Lack of autocorrelations........................................................................................ 78

5.5.2 Volatility clustering............................................................................................... 79

5.5.3 Heavy tails............................................................................................................. 79

5.5.4 Conditional heavy tails.......................................................................................... 80

5.5.5 Non-Gaussianity.................................................................................................... 81

5.6 The Simulation .................................................................................................................. 81

5.6.1 Lack of autocorrelations........................................................................................ 82

5.6.2 Volatility clustering............................................................................................... 83

5.6.3 Heavy tails............................................................................................................. 84

5.6.4 Conditional heavy tails.......................................................................................... 85

5.6.5 Non-Gaussianity.................................................................................................... 85

5.7 Experimentation with artificial carbon markets ................................................................ 85

5.7.1 Wealth distribution of agents (W)......................................................................... 86

5.7.2 Proportion of carbon allowances vis-à-vis total wealth (P) .................................. 87

5.7.3 Number of agents (N)............................................................................................ 88

5.8 Results and discussion of Experiments ............................................................................. 88

5.8.1 Changing W........................................................................................................... 89

5.8.2 Changing P ............................................................................................................ 90

5.8.3 Changing N ........................................................................................................... 91

5.8.4 Comparison with analytical models ...................................................................... 92

5.9 Summary and conclusions................................................................................................. 94

6 Conclusions, Policy Implications, Limitations and Future Work ............................................ 96

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6.1 Conclusions ....................................................................................................................... 96

6.2 Policy Implications............................................................................................................ 99

6.3 Limitations and Future Work .......................................................................................... 100

References ................................................................................................................................... 103

Appendix-1.................................................................................................................................. 113

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List of Tables

Table Page

3.1 Data description for the price series of carbon markets in EU, USA and Canada for both Allowance and CER based assets (credits)…………….. 26

3.2 Results of ADF and Phillips-Perron unit root tests for carbon prices in the markets of EU, USA and Canada…………………………………… 28

3.3 Results of DF-GLS and Zivot-Andrews unit-root tests for carbon prices in the markets of EU, USA and Canada………………………………… 29

3.4 Results of Johansen’s multivariate co-integration tests for the carbon markets of EU, USA and Canada for both Allowance and CER based credits of EUA, CCXA, RGGIA, MONTLA, EUCER, and CCXCER (using 3 lags)….. 30

3.5 Results of Johansen’s multivariate co-integration tests for carbon markets of EU, USA and Canada for both Allowance and CER based credits of EUA, CCXA, RGGIA, MONTLA, EUCER, and CCXCER, taking five assets at a time (using 3 lags)…………………………………………………… 31

3.6 Results of Johansen’s multivariate co-integration tests for carbon markets of EU, USA and Canada for both Allowance and CER based credits of EUA, CCXA, RGGIA, MONTLA, EUCER, and CCXCER, taking four assets at a time (using 3 lags)…………………………………………… 31

3.7 Results of Johansen’s multivariate co-integration tests for only Allowance-based credits of CCXA, RGGIA and MONTLA in North America only (using 3 lags)……………………………………………… 33

3.8 Results of Johansen’s multivariate co-integration tests for carbon markets of EU and North America for CER-based credits EUCER and CCXCER (using 3 lags)…………………………………………………… 34

4.1 Summary statistics of the volatility series and tests for non-stationarity for ECX and CCX………………………………………………………... 54

4.2 Results of DF-GLS and Zivot-Andrews unit-root tests for carbon prices in ECX and CCX………………………………………………………… 55

4.3 Results for performance of econometric models for ECX Options Market……………………………………………………………………. 56

4.4 Results for performance of econometric models for ECX Futures Market 57

4.5 Results for performance of econometric models for CCX, Spot Market... 58

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5.1 Statistics for log returns for price in ECX and CCX…………………….. 80

5.2 Summary statistics for log returns of prices of actual and simulated markets…………………………………………………………………… 81

5.3 Statistics for the log returns for the price series of the simulated carbon markets of ECX and CCX……………………………………………….. 84

5.4 Results of experiments on artificial carbon markets for different wealth distribution of agents…………………………………………………….. 89

5.5 Results of experiments for changing the proportion of carbon assets…… 90

5.6 Results of experiments for changing N in ECX…………………………. 91

5.7 Results of experiments for changing N in CCX…………………………. 92

5.8 Results of forecasting ECX and CCX with GARCH (1, 1) and ABM...… 93

5.9 Results of forecasting CCX spot market with NL-GARCH and ABM…. 94

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List of Figures

Figure Page

3.1 Allowance and CER asset prices in carbon markets of EU and North America………………………………………………... 27

3.2 Graph of structural stability tests using Eigenvalue stability condition in VEC model for Allowance-based assets CCXA, RGGIA and MONTLA in North America…………………….. 33

3.3 Graph of structural stability tests using Eigenvalue stability condition in VEC model for CER-based assets EUCER, and CCXCER in EU and North America…………………………… 35

4.1 Price in ECX Options Market, Oct. 2006 to Jul. 2009……….. 52

4.2 Volatility in ECX Options Market, Oct. 2006 to Jul. 2009…... 52

4.3 Price in ECX Futures Market, Mar. 2006 to Jul. 2009……….. 52

4.4 Volatility in ECX Futures Market, Mar. 2006 to Jul. 2009…... 52

4.5 Price in CCX, Dec. 2003 to Jul. 2009………………………… 53

4.6 Volatility in CCX, Dec. 2003 to Jul. 2009…………………… 53

5.1 Cycle of an agent based model in Adaptive Modeler………… 73

5.2 Closing Prices ECX…………………………………………... 77

5.3 Log Returns ECX…………………………………………….. 77

5.4 Closing Prices CCX…………………………………………... 78

5.5 Log Returns CCX…………………………………………….. 78

5.6 Autocorrelations log returns ECX……………………………. 79

5.7 Autocorrelations log returns CCX……………………………. 79

5.8 Autocorrelations absolute log returns ECX…………………... 80

5.9 Autocorrelations absolute log returns CCX…………………... 80

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5.10 Autocorrelations log returns ECX, VMP……………………... 82

5.11 Autocorrelations absolute log returns ECX, VMP…………… 82

5.12 Autocorrelations log returns CCX, VMP…………………….. 83

5.13 Autocorrelations absolute log returns CCX, VMP…………… 83

5.14 Autocorrelations log returns ECX, BAP……………………... 83

5.15 Autocorrelations absolute log returns ECX, BAP……………. 83

5.16 Autocorrelations log returns CCX, BAP……………………... 84

5.17 Autocorrelations absolute log returns CCX, BAP……………. 84

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List of Appendices

Appendix Page

Appendix-1 Genetic Programming Flowchart, adopted from Koza (1992)………... 113

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1 Introduction

1.1 Climate Change and Carbon Emissions

Climate change is recognized as one of the biggest challenges before mankind in the 21st

century. This thesis is devoted to carbon markets-a market-based solution designed to

address this problem. However, to understand the context within which these markets

operate, it is necessary to have some knowledge of the physical basis, causes and likely

impacts of climate change.

The problem of climate change is a consequence of the greenhouse effect- a natural

phenomenon that maintains an average temperature of 150C on earth, allowing life to

exist (IPCC 2007, 3). Greenhouse effect is caused by the natural presence of greenhouse

gases (GHGs), which trap part of the sun’s heat in the atmosphere. These gases are

carbon dioxide (CO2), methane, nitrous oxide, sulphur hexafluoride, hydrofluorocarbons

and perfluorocarbons. Due to excessive accumulation of these gases in the atmosphere,

the problem of climate change occurs. CO2 is the primary cause of the human induced

greenhouse effect, which comes mainly from burning fossil fuels and deforestation.

Another greenhouse gas, namely methane comes from burning of forests, ruminant

livestock, rice paddies, farms and landfill gas. Other GHGs, such as nitrous oxide (NOX)

comes from fertilizers and some chemical processes, halocarbons from refrigerant gases

and tropospheric ozone is released by combustion of hydrocarbons (Brohe et.al. 2009, pp.

6).

1.2 Role of forests in carbon emissions and sequestration

Climate change and forests are intrinsically linked and have both cause and effect

relationship with each other. Changes in global climate affect forests in a negative way

through higher mean annual temperatures, altered precipitation patterns and extreme

weather events. The most dramatic release of heat in the atmosphere occurs in forestry

sector on account of forest fires. In some rich regions of the world like southeast

Australia, western Canada, the western United States, and in southern Europe, this

appears to be a particularly growing problem. A second factor is the impact of warmer

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weather on the spread of pests, such as mountain pine beetle, which kill trees and thereby

provide significantly more readily combustible material. In addition, windstorms in

Northern Europe also lead to very significant losses in forestry (Labbat and White 2007,

9-10). Furthermore, when forests are destroyed or over-harvested and burned, they can

become sources of carbon and contribute to climate change.

On the positive end, forests and wood products in long-term use trap and store carbon

dioxide, playing a major role in mitigating climate change. Trees help remove CO2 from

the atmosphere and converting it during photosynthesis to carbon, which they store in the

form of wood and vegetation, a process known as carbon sequestration (Brohe et.al.

2009, 10). In addition to trees themselves, the overall biomass of forests also acts as a

carbon sink. Therefore, serious action should be taken now to manage the complex

relationships between forests and climate change in a more holistic manner.

1.3 Role of carbon markets in forest investment decisions

In the present climate change scenario, carbon markets play a major role in forest

investment decisions. Looking at the global picture, various funds have been created by

different international organizations. The World Bank, for example, has created Forest

Carbon Partnership and Forest Investment Program, under which the Reduced Emissions

through Deforestation and Degradation (REDD) and the Clean Development Mechanism

(CDM) projects are funded in the developing countries. In return, emission credits are

awarded to the developed countries, which contribute to establishment of these funds

(REDD 2011, 1-2). Voluntary carbon markets like Chicago Climate Exchange also allow

buying and selling of forest carbon credits (CCX 2010, 2).

However, an investor like a forest manager or farmer at the local level will make forest

carbon investment decision purely on the basis of price dynamics of credits in the carbon

market. Her investment for carbon forestry will depend on the opportunity cost that she

has to incur by not subjecting her valuable land to other competing land uses like

agriculture, timber-forestry and recreation. Hence she will be very much interested in

understanding the price mechanism of carbon markets.

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1.4 Literature Review

Functioning of carbon markets under the Kyoto Protocol is similar to that of any other

financial market. However, the commodity traded in carbon markets is CO2, which

affects the climate, a global public good (Brohe et.al. 2009, 22-24). Existing carbon

market research could be divided into three major categories: policy papers, theoretical

papers, and papers related to economic analysis. These are described in the following

paragraphs.

For policy matters, Johnson and Heinen (2004) made a future estimate of carbon trading

and projected that by 2010, the EU scheme would trade as much as $1 billion worth of

allowances each year. Their paper concluded that industry should get involved in carbon

trading and advance their interests. A policy paper by Godal and Klassan (2006)

examines the potential effects on permit prices and abatement costs of four compliance

rules governing emissions trade across sources and periods in the Kyoto Protocol: The

banking rule that allows excess permits to be used later; the restoration rate rule that

penalizes borrowing; the commitment period reserve rule that limits sales; and finally, the

suspension rule that restricts borrowing and sales. Veld (2005) considers socially optimal

carbon sequestration and abatement decisions under different expectations about future

carbon prices. It is shown that if carbon prices increase over time, consistent with

projections from integrated assessment models under various assumptions about future

climate-policy goals, it becomes optimal to delay certain carbon sequestration projects,

whereas the optimal timing of abatement projects remains unchanged.

As far as the theoretical papers are concerned, Copeland and Taylor (2005) provide a

trade theory view of the Kyoto Protocol. They demonstrate how several important results

in environmental economics, true under mild conditions in closed economies, are false or

need serious amendment in a world with international trade in goods. Convery and

Redmond (2007) have given a framework for market and price developments in the

European Union Emissions Trading Scheme (EU ETS). A comparison between carbon

taxes and emissions trading has been made by Mandell (2008). He argues that in practice,

different emitters of a particular pollutant are sometimes subjected to different control

mechanisms. This paper is aimed at analyzing whether, from an efficiency point of view,

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it is preferable to divide a regulated economy into two sectors, subjecting one sector to

cap-and-trade and the other to an emissions tax, rather than adopting the cost effective

approach of subjecting the entire economy to either cap-and-trade or an emissions tax. It

shows that mixed regulation can be superior. Streck, Tuerk and Schlamadinger (2009)

examine offset projects and argue that forestry offsets should be integrated with EU ETS

for increasing efficiency. Mehling and Haites (2009) and Persson (2009) describe

mechanism for linking carbon markets theoretically. Anger (2007), by way of simulation

studies, assesses the economic impacts of the linked carbon markets; whereas, Haites and

Wang (2009) prescribe a framework for ensuring the environmental effectiveness of such

linked markets.

Among papers relating to economic analysis, Uhrig-Homburg and Wagner (2007)

examine the future price dynamics of CO2 emission certificates through an empirical

analysis of relationship between spot and future markets in EU ETS. Oberndorfer (2008)

carries out an econometric analysis on EU emission trading scheme. This paper claims to

be the first econometric analysis on stock market effects of the EU Emission Trading

Scheme. The focus of research is specifically on the electricity units. It analyses

electricity stock return reactions to changes in EU Emission allowance prices. A big

limitation of this paper is that it is focused only on the electricity firms. Paolella and

Taschini (2008) carries out an econometric analysis of emission allowance prices in

North American SO2 and CO2 markets through examination of their stylized facts.

Seifert, Uhrig-Homburg and Wagner (2008) study the dynamic behavior of CO2 spot

prices. Benz and Trück (2009) analyze the short-term price behavior of carbon

allowances in EU ETS through review of stylized facts and modeling the return of

emission allowances.

Despite of the volume of research in carbon markets, there are some gaps in the literature,

which need to be addressed by way of further exploration of this area. Such gaps are

described subsequently.

First, market integration and the value of diversification of portfolios among countries is

an important factor in investment decision making. The same is true of carbon markets.

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Due to the recognition of trade in emission allowances or permits in organized carbon

markets for meeting emission reduction targets under Kyoto Protocol, several national

and regional carbon markets have been established around the world. Hence there is a big

need to unify carbon market instruments to overcome problems across fragmented and

less efficient markets (Zoellick 2007). A deep and global market can deliver significant

benefits to all participants, including low-cost abatement options and helping set effective

price signals. It will also bring opportunities for deepening sustainable development that

can be supported through enhanced technical and financial cooperation. Increasing

integration of world carbon markets could imply better diversification opportunities and

fewer tendencies for arbitrage (World Bank 2007, 7-8). Also Majid et.al. (2008) suggest

that investors should invest internationally because of the risk reduction that stems from

the lower correlation between assets of different countries. So from research point of

view, study of market integration is the first and foremost factor for the emerging carbon

markets. A lot of research has been carried out for financial markets in this direction, for

example by, Su et.al (2007), Moroza (2008), and Elfakhani et.al (2008). In the case of

forest products, market integration of the US and Canadian softwood lumber markets is

analyzed by Shahi, Kant and Yang (2008) using Vector error correction model and the

Johnson approach. However, such integration techniques have hardly ever been used to

explore the possibility of unification of world carbon markets.

Second, carbon markets, despite their voluminous growth, have experienced a lot of

fluctuations since their very inception, which are caused by market uncertainties. A full

understanding of volatility of carbon prices is, therefore, critical from multiple

perspectives as it poses a significant threat to industries and economies in a carbon

constrained world. First, the short-run price volatility could discourage the deployment of

new capital intensive abatement technologies, by giving rise to an option value from

delaying irreversible investments (Chao and Wilson, 1993). Second, for most of the

investment decisions, volatility shall determine the return on capital. Third, price

volatility may have some major disruptive effects on the price dynamics of the market.

Lastly, forecasts of carbon price volatility could be important inputs into macro-

econometric models and market risk assessment calculations like value at risk and; for

the purpose of forecasting return series, more accurate intervals can be obtained by

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modelling volatility of returns (Yu, 2002). Price volatility, therefore, is one of the key

determining factors in the choice of a carbon policy instrument. A lot of research has

been carried out forecasting volatility in the financial markets other than carbon markets,

for example, by Yu (2002), Balaban (2006), Wang and Lin (2007) and Bernard et.al

(2008). For energy markets, a model for forecasting oil markets has been developed by

Kang, Kang and Yoon (2008). However, relatively little work has been done so far on

modeling and forecasting carbon market price volatility from an econometric or risk

management angle.

Lastly, the traditional approach for forecasting price in financial markets is through use of

analytical models (Tesfatsion 2005, 1). Complexity of carbon markets represents a big

challenge to that approach. Most analytical models make simplifying assumptions, such

as perfect rationality and homogenous agents, which may cause biased results and

demand alternative methods. Agents like different countries, organizations, industries and

individuals are involved in the process of carbon trading, both on the demand side and the

supply side. These agents interact with each other and with the overall trading-

environment to evolve the emergent behavior of these markets (Axelrod and Tesfatsion

2005, 2-3). Therefore for obtaining better forecasts, it is necessary to incorporate agent

behavior in carbon markets. Agent based models have been found to give promising

results for financial markets (LeBaron 2000). They have been used in the past to model

ecosystems (Grimm 1999), economic systems (Thebaud and Locatelli 2001), and social

systems (Axelrod 1997). Hoffmann et.al. (2007) make use of social simulation in linking

micro-level investor behavior and macro-level stock market dynamics. In financial

markets, agent-based computational modeling is used by Chen and Liao (2007), who

examine the possible explanations for the presence of the causal relation between stock

returns and trading volume. Chen and Yeh (2001) use two well known hypotheses in

economics to illustrate how emergent properties can be shown in an agent-based artificial

stock market. Situngkir and Suya (2005) construct an agent-based model as a form of

advanced study for financial economic post-statistical-data and micro-simulation

analysis. These studies explain how agent based modeling is used to describe the

behavior of various stock markets. However, these techniques have hardly ever been used

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to model the newly emerging carbon markets and could be used to study their behavior

also.

1.5 Organization of thesis

To fill the identified gaps in the existing literature, this research carries out detailed

economic analyses of world’s carbon markets. The specific objectives of this thesis are:

(i) to analyze the long-run market integration indicated by cointegration between carbon

prices in various markets of the world; (ii) to forecast short-term volatility in different

carbon markets; and (iii) to develop an agent based model of carbon markets and

compare it with analytical models for the purpose of forecasting. The dissertation is

composed of three independent papers that are written in journal article style and address

these issues.

The first paper addresses the long-run integration of carbon markets at the interregional

level using the Johansen full information maximum likelihood procedure for testing co-

integration. The main findings of the paper suggest that all carbon markets of the world

are not integrated. North American carbon markets are integrated with each other and so

are the CDM markets. For future, it is expected that the possibilities of arbitrage across

the global markets will be limited, and the carbon trading in these markets will be

globally inefficient. Hence, there is a strong need of a global agreement that allows global

carbon trade to prevent climate change at the least cost options.

The second paper evaluates the performance of various econometric models, both simple

and complex, for predicting short-term price volatility in European Climate Exchange

(ECX) and Chicago Climate Exchange (CCX). Results suggest that the voluntary carbon

market of CCX is relatively more volatile and is forecasted best by complex model like

non-linear GARCH; and this behavior of this voluntary market is similar to that found in

other financial markets and energy markets. The compliance market of ECX, on the

other hand, is less volatile and is forecasted best by simple econometric models like

Historical Averages and GARCH (1, 1) and hence is different from other markets. These

results might be useful for anyone interested in carbon market volatility.

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The third paper considers agent based models, which are the bottom-up simulations of

actions, incorporating interactions of such heterogeneous entities in the carbon market.

Artificial carbon markets obtained from such agent based models for the spot markets of

European Climate Exchange (ECX) and Chicago Climate Exchange (CCX) have stylized

facts – lack of autocorrelations, volatility clustering, heavy tails, conditional heavy tails,

and non-Gaussianity; which are similar to the actual carbon markets. These models are

found to possess considerably higher forecasting capabilities than the traditional

econometric models. Experiments performed on these artificially simulated carbon

markets by changing wealth distribution of agents, by varying the distribution of

proportion of carbon assets, and lastly by changing the number of agents in the carbon

market, show that forecast accuracy is further improved considerably, when the values of

these agent parameters are closer to real market situations. Agent based models could

play a key role in mimicking the real world carbon markets and could provide an

alternative to the analytical models for better forecasting.

The remaining dissertation is organized as follows: Chapter 2 gives an overview of

carbon markets. Chapter 3 contains the first essay titled “Cointegration of EU and North

American Carbon Markets”. Chapter 4 comprises the second essay titled “Forecasting

Volatility of Carbon Markets”. Chapter 5 consists of the third paper titled “An Agent

Based Model of Carbon Markets”. Lastly, Chapter 6 covers the summary and

conclusions. In addition, since this dissertation is written in an independent paper style

format, some repetitions in explanation of terminology and other aspects of carbon

markets are bound to occur here and there in different chapters.

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2 Overview of World’s Carbon Markets

2.1 Carbon Trading

Carbon-trading is an administrative approach used to control emission of Carbon dioxide

(CO2) by provision of economic incentives. A central authority sets a limit or cap on the

amount of carbon that can be emitted (Marcu 2006, pp. 8). Companies, individuals or

other groups are issued emission permits and are required to hold an equivalent number

of allowances (or credits) which represent the right to emit a specific amount. The total

amount of allowances and credits cannot exceed the cap, limiting total emissions to that

level. Companies that need to increase their emission allowance must buy credits from

those who pollute less (Soleille 2006). In effect, the buyer pays a price for emitting, while

the seller is rewarded for having reduced emissions by more than was needed. Over the

last few years, such trading has given rise to the evolution of carbon markets.

2.2 Economic theory behind carbon markets

For stabilizing the levels of carbon in the atmosphere, we need not only to focus on forest

conservation, clean energy technologies and emission reduction strategies, but also must

generate the market pull for them. Carbon markets are among the most innovative and

cost-effective methods for creating market pull for forestry credits and new clean energy

technologies while, at the same time, putting a price on emission and thereby providing

incentives for people to emit less (Karmali 2010, pp. 61). Carbon markets are able to

achieve this aim because they help channel resources toward the most cost effective

means of reducing GHG emissions. They also punish those who emit more than an

established quota, and reward those who emit less (Stern 2006, pp. 27). The market based

approach also allows third-party players, such as speculators, to enter the fray and make

investments in green endeavour. Other interested parties also can get involved. If, for

example, an environmental group wants to see emissions decrease below a regulated

target, they can raise money to buy and retire emission allowances. This drives up the

costs of emissions and can force emitters to become more efficient (Bayon, Hawn and

Hamilton 2007, 55).

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2.3 Types of carbon markets

The term carbon market refers to the buying and selling of emissions permits that have

either been distributed by a regulatory body or generated by Greenhouse Gas (GHG)

emission reduction projects. GHG emission reductions are traded in the form of carbon

credits, which are equal to one metric ton of CO2, (tCO2e), the most common greenhouse

gas (IPCC 2007, 1-4). Carbon markets can be separated into two major categories:

compliance markets and voluntary markets.

2.3.1 Compliance Markets

Compliance markets are created and regulated by mandatory regional, national, and

international carbon reduction regimes like the Kyoto Protocol (Brohe et.al. 2009, 12).

The biggest success of compliance markets so far has been to send market signals for the

price of mitigating carbon emissions. The total traded volume in the compliance carbon

market grew from 4.8 Giga-tons (Gt) in 2008, to 8.7 Gt in 2009 (Kossoy and Ambrosi

2010, 1-2). Demand is driven by the emitters who must operate within proportion of the

cap that has been allocated to them. An emitter has to buy additional emission permits, as

soon as it exceeds the amount that has been initially allocated to it. However, demand

falls due to employment of mitigation technologies or due to fall in the production output

of the firm (Brohe et. al 2009, 25-26).

2.3.2 Voluntary markets

Voluntary carbon markets function outside of the compliance markets, enabling

companies and individuals to purchase carbon offsets on a voluntary basis. The voluntary

market reflects the sum of all transactions of carbon credits and allowances, where the

final purpose of cancelling or retiring the carbon credit is not to comply with legislation

or to fulfill agreements between companies and governments. The voluntary carbon

market, although much smaller than the compliance market, is now growing rapidly

(Point Carbon 2004).

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2.4 Existing carbon markets

Kyoto Protocol established the principle of trading carbon emissions between countries to

reduce GHGs by following low cost options. However, the actual emitters are not

countries themselves, but the companies, transport systems, logging industries and

households operating within the boundaries of those countries. Carbon trading is

therefore carried out by such agents due to fixing of emission reduction targets by the

regulators or as a matter of emissions reduction on voluntary basis. To facilitate this

mechanism of emissions trading, various carbon markets have come up across the length

and breadth of the globe. Some of these markets are compliance markets and others are

voluntary ones. Carbon markets that have been considered in this dissertation are

described briefly in this section.

2.4.1 EU Emissions Trading Scheme

EU ETS is the largest carbon market established in the world till date. Nearly 10,000

installations are included in its scope, which comprise of thermal power stations more

than 20 MW, mineral oil refineries, coke ovens, iron production and processing, mining,

glass, ceramics and paper and pulp. EU ETS was launched in 2005 and is a cap-and-trade

scheme that covers nearly half of EU’s carbon emissions (Soleille 2006). To ensure

market liquidity, a trading platform, namely European Climate Exchange (ECX) has been

established. Its primary function is to contribute to the liquidity in the market and offer

customers the benefits of reduced transaction costs, lesser risks, guarantee of anonymity

and price transparency (Labbat and White 2008, 143-147). Data from ECX have been

used for the purpose of this dissertation.

2.4.2 Clean Development Mechanism (CDM)

Under the Clean Development Mechanism (CDM), a developed country (also called

Annex-I country under Kyoto Protocol) invests in a developing (Non-Annex-I) country

for the purpose of reducing GHG emissions and also promoting sustainability principles

in the latter. For every ton of CO2 reduced or absorbed through the project, the investor

receives a Certified Emission Reduction (CER). Development of a CDM project can be

unilateral, bilateral or multilateral. Unilateral project development is planned and

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financed within a developing country, whereas, in a bilateral model, one or more

developed countries finance and implement the project (Brohe et.al 2009, 42-53).

Multilateral CDM projects take the approach of a mutual fund in which the investments

flow from a centrally managed fund like the one by World Bank to projects in the host

countries. Each of these different structures has advantages and disadvantages in terms of

incentives, risks and transaction costs. Most of the forestry projects in developing

countries fall in this category.

2.4.3 Carbon Markets in the USA

While the United States of America pioneered emissions trading in its regulation of

sulphur dioxide (Feldman and Raufer 1987), the development of carbon trading at

national level has been slow to emerge. However, some action has been taken at the

regional and State level. In addition to establishing three regional emissions trading

schemes, 17 states have established state-wide emission targets. The initiatives are likely

to result in a national emissions trading system with long term aim of reducing national

emissions by 80 percent by 2050 (White House 2009, 1-2). Different carbon markets that

are in operation or development within the US are described here.

2.4.3.1 Chicago Climate Exchange (CCX)

CCX was the first voluntary, legally binding rule-based greenhouse gas emission

reduction and trading system launched in 2003. Carbon credits traded in CCX are called

Carbon Financial Instruments (CFIs). The exchange restricts trading to members who

have voluntarily signed up to its mandatory reductions policy (Bayon, Hawn and

Hamilton 2007, 50). The majority of trade in CCX is allowance based, rather than project

based. Whenever the offset projects are used, CCX requires that an approved third party

organization verify that the project’s emission reductions are real and they meet standards

set by the exchange. Data from CCX has been extensively used in this dissertation.

2.4.3.2 Regional Greenhouse gas Initiative (RGGI)

RGGI was the first mandatory US cap-and-trade program for CO2. Ten northeastern and

mid-Atlantic states, namely Connecticut, Delaware, Maine, Maryland, Massachusetts,

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New Hampshire, New Jersey, New York, Rhode Island and Vermont are part of this

initiative (Brohe et. al 2010, 153-155). These participating states negotiated state-wide

caps largely on the basis of historical emissions. Aggregated, these caps form the regional

RGGI cap. The cap is set on fossil-fuel fired power plants of at least 25 MW, covering

about 225 facilities (RGGI 2010, 1-2). It also allows for the use of offset projects for

compliance.

2.4.3.3 Western Climate Initiative (WCI)

WCI plans to lay the foundation for an international cap-and-trade program that would

involve both the US and Canada. It involves the states of Arizona, California, Montana,

New Mexico, Oregon, Utah and Washington, and the Canadian provinces of British

Columbia, Manitoba, Ontario and Quebec (Brohe et. al 2010, 168-169). Various other

states have joined as observer states also. The WCI program is expected to cover about

90 percent of GHG emissions in participating American states and Canadian provinces

once it is fully implemented in 2015 (WCI 2010, 1-2).

2.4.3.4 Midwestern Regional Greenhouse Gas Reduction Accord (MGA)

MGA was established in 2007 by six states of USA, namely Illinois, Iowa, Kansas,

Michigan, Minnesota and Wisconsin and one Canadian province of Manitoba. They set a

long term target of emission reduction below 60-80 percent below current emission levels

and develop a multi-sector cap-and-trade system to achieve this target (Hight and Silva-

Chavez 2008).

2.4.4 Canadian Carbon Market

For tackling the issue of climate change, causing severe environmental and economic

risks, the Government of Canada has decided to adopt intensity-based greenhouse gas

(GHG) emissions reduction targets. In addition to following technology based methods,

the market solution of carbon markets is also prescribed for. Therefore, the Montréal

Climate Exchange (MCeX) has been established in collaboration with the Chicago

Climate Exchange (CCX) to launch trading of futures contracts. These contracts allow

regulated industrial participants to manage their emissions risks at the lowest cost while

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also creating continuous incentives for technological innovation. The new MCeX

contract, traded on the Montréal Exchange's electronic trading platform gives key

regulated industrial emitters and other potential stakeholders the price signals needed to

measure the price of CO2 (MCeX, 2010).

Various other carbon markets have also emerged in different part of globe like those in

China, Japan, Australia, India and New Zealand (Brohe et. al 2010, 198-244). However,

most of these markets are in nascent stage and very little data are available from them for

carrying out any meaningful econometric analysis. Therefore, this dissertation makes use

of data from the carbon markets in EU and North America only. With availability of new

data, the analysis of subsequent chapters can be extended to other parts of the world also.

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3 A cointegration analysis of Carbon Prices in EU and North America

Abstract

Several national and regional carbon markets have already become functional around the

world, and there is a need to integrate them to overcome problems across fragmented and

less efficient markets. In this chapter, integration of the EU and North-American carbon

markets is studied using the Johansen full information maximum likelihood procedure for

testing cointegration. All carbon markets across the EU and North America are not

integrated. However, co-integration is observed among the certified emission reduction

assets traded in the EU and North America, depicting the integration of clean

development mechanism project markets. In addition, cointegrating relationships are

present within allowance-based markets of North-America, but allowance markets of the

EU do not show co-integration with the North American counterparts. For future, it is

expected that the possibilities of arbitrage across the global markets will be limited, and

the carbon trading in these markets will be globally inefficient. Hence, there is a strong

need of a global agreement that allows global carbon trade to prevent climate change at

the least cost options.

Key words: Carbon markets, Climate Change, Cointegration, and Johansen maximum

likelihood procedure.

3.1 Introduction

Climate change through greenhouse gas (GHG) emissions is now established as a major

policy challenge for governments and the international policy makers. To address this

issue, Kyoto Protocol was put in place in 1992 by the United Nations Framework

Convention on Climate Change (UNFCCC). One of the main mechanisms of GHG

reduction recommended by the Protocol is trading of emission allowances or permits,

primarily of carbon dioxide (CO2), in organized markets. Several national and regional

carbon markets have been established around the world, in which a variety of specialized

instruments are traded. Europe has emerged as a leader in the emissions trading industry

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with the European Union Emissions Trading Scheme (EU ETS) being the world’s largest

single market for CO2 emission allowances, accounting for approximately 97% of the

global transactions in 2010 (Linacre, Kossoy and Ambrosi 2011, 1). China has remained

the largest Clean Development Mechanism (CDM) project seller during this time. The

most significant change in policy landscape over the past years, however, is the re-

emergence of the United States in the climate change debate. The Waxman-Markey Bill

of the U.S. provided for the international emissions allowance trading (Daskalakis,

Psychoyios and Markellos, 2009). Though there was not enough support to pass this

legislation at the federal level, many carbon markets have already become operational at

the regional levels. The demand of carbon credits from EU and USA is expected to create

an opportunity for developing countries also to become part of carbon market mechanism

(Capoor and Ambrosi, 2009). Regarding future of carbon markets, there are various

reasons for optimism. The Copenhagen accord of the UNFCCC prescribes to continue the

carbon market approach to enhance the cost-effectiveness of, and to promote mitigation

actions of climate change (CoP, 2009). The same has been reiterated by Cancun

conference also. Progress at Cancun has been welcomed by the market and helped to

restore some confidence in UN negotiations on climate change. Various national and

local initiatives, for example, California’s cap-and-trade scheme, Western Climate

Initiative and Regional Greenhouse Gas Initiative have noticeably picked up and may

offer the potential to collectively overcome the international regulatory gap. Apart from

these initiatives, various carbon markets have gained increasing traction in developing

economies such as Brazil, China, India, and Mexico (Kossoy and Ambrosi 2010, 4-5).

Carbon markets have been established in different countries and regions, depending on

the differences in their level of commitment to tackle climate change and the differential

amount of reductions required under Kyoto Protocol. As a result, price structure of

carbon might be different among them, resulting in inefficiencies (Linacre, Kossoy and

Ambrosi 2011, 7-22), because prices do not fully reflect the available information in the

market in this case. However, market integration ensures efficiency gains, increased

market liquidity, and the reduced volatility (Flaschsland, Marschinski and Edenhofer

2009) by making carbon credits available to right agents at the right price through

removal of information gaps. In political terms, integration between different emission

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trading schemes, can ensure carbon-market-based cooperative climate policy across

international borders (EU Commission, 2009). This chapter investigates an important

issue in international carbon trading, which has got significant enviro-political

implications: Are carbon markets regionally segmented or have they evolved into a

global, integrated market, thus deriving the benefits of economic efficiency and

international cooperation? Given the importance of carbon trading under present climate

change scenario, this question is also of high relevance for framing of environmental and

economic policy by different countries.

This analysis is motivated by the following factors: First, carbon markets have emerged

at regional, national and international levels. The regional segmentation has been

established due to different policy stands taken by the respective governments at not only

the national levels but also at provincial levels in different countries. To drive emission

reductions, countries and regions adopt a range of domestic policies that may focus on

cap-and-trade schemes, baseline and credit mechanisms, renewable energy and energy

efficiency certificates, carbon taxes, subsidies or emission standards. In many cases,

multiple policy approaches are being used that may be complementary and sometimes

contradictory, and which often have different costs and benefits accruing at different

times and geographical scales (Kossoy and Ambrosi 2010, 25). As a result, carbon

markets established in different regions are governed by specific demand and supply

patterns. Second, climate policy at the global level is going through a period of critical

transformation. There is a need to unify carbon market instruments to overcome problems

across fragmented and less efficient markets. In words of Zoellick (2008), “A deep and

global market can deliver significant benefits to all participants, including by expanding

low-cost abatement options and helping set effective price signals. It will also bring

opportunities for deepening sustainable development that can be supported through

enhanced technical and financial cooperation”. Increasing integration of world carbon

markets could imply better diversification opportunities, less concerns about availability

of carbon credits, more competition among the supplying regions and less tendencies for

arbitrage (Stern 2006). Third, with the growing number of emission trading systems,

there has been an increased interest in the feasibility of integrating distinct programs, as

firms may take advantage of a range of marginal abatement costs of firms in the

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integrated system (Flaschsland, Marschinski and Edenhofer 2009). At the countries’ level

also, when different trading schemes are linked, the prices tend to equalize. Sources in

the countries with higher permit price purchase permits from sources in the country

where price of permits is lower until the prices and hence marginal abatement costs

(MACs) are equalized across the two countries with total emissions remaining the same

(Kruger, Oates and Pizer, 2007). Studying integration of carbon markets can be helpful in

taking policy level decision of linking various emission trading schemes. The first step in

the study of integration of carbon markets is examination of the Law of One Price (LOP)

among different carbon markets of the world. The existence of the LOP between various

markets would indicate that the CO2 prices in different markets move together, and the

differences in local policies and price mechanisms should not be of great concern for

overall international carbon trading. Hence the existence of LOP between national and

regional carbon markets is examined in this chapter.

The importance of market integration using LOP is very well documented in the

economics literature and various authors, including Egert and Kocenda (2007), Florus

and Vougas (2008) and Valadkhani and Chancharat, (2008) have tested market

integration for primary equity markets. He et.al. (2010), and Maghyereh and Kandari,

(2007) have carried out market integration studies for oil, electricity and natural gas

markets. Uri and Boyd (1990), Jung and Doroodian (1994), and Shahi, Kant and Yang

(2006) have tested LOP for integration of softwood lumber markets. Regarding carbon

markets, Anger (2008) assesses the economic impacts of linking the EU emissions

trading schemes to emerging schemes beyond Europe in the presence of a post-Kyoto

agreement in 2020. His paper concludes that from an efficiency perspective, the most

desirable future climate policy regime should be represented by a joint trading system

facilitating international emissions trading between ETS companies across the countries.

He also favours linking cap-and-trade systems with the Clean Development Mechanism

projects in developing countries to ensure large scale cost savings. Mehling and Haites

(2009) discuss mechanisms for linking greenhouse gas emission trading schemes. The

mechanisms are legal and institutional arrangements to integrate between various

emissions trading schemes and sustaining their integrity over time. Persson (2009) argues

that linking North east states of the US mitigation program to the EU emission trading

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scheme would encourage a change of the federal US policy, which traditionally has

followed action taken at the state level. Flaschsland, Marschinski and Edenhofer (2009)

have devised a framework to assess direct bilateral cap-and-trade linkages through an

analysis of the economic, political and regulatory framework that indicates potential

benefits along with a number of potentially negative side effects. Their study indicates

that, due to presence of market distortions or terms-of-trade effects, international

emissions trading may not be welfare-enhancing for all countries. Their paper also

assesses a linkage between the EU ETS and a prospective US trading system and

identifies the major trade-offs. Sterk and Kruger (2009) examine the current emissions

trading debates in the EU and the USA and analyze the prospects for creating a

transatlantic carbon market. They question the compatibility of the design of USA

emissions trading schemes and the EU ETS. Their paper argues that crucial differences

relate to the stringency of targets, the recognition of offsets, and price control

mechanisms and suggests that the two sides should seek a way forward that reconciles

potentially different climate policies. The paper recommends that the USA and the EU

should consider an effort to harmonize carbon prices and should have mechanisms that

allow periodic recalibration, which would allow each to adjust to new technology, react

to developing-country climate policies, and learn from each other. However, none of

these papers focus on actual price dynamics in carbon markets for exploring the

feasibility of integrating them. To the best of my knowledge, there is no study that has

tested the LOP for different national and regional carbon markets or emission trading

schemes.

This chapter addresses the integration of carbon markets at both international and inter-

regional levels. The main objective of this chapter is to test the LOP among the carbon

markets of EU and North America. Other carbon markets of the world are still in the

nascent stages (Benz and Trück 2009) and not enough data are available from them to

carry out any meaningful econometric analysis. In particular, the structure of the carbon

markets of EU and North America is analyzed using the Johansen full information

maximum likelihood procedure for testing co-integration. The presence of cointegration

between the prices of different geographic markets and different carbon assets is

interpreted as evidence of carbon market integration. The study contributes to the existing

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literature in three major aspects. First, three carbon markets namely EU, US and Canada

have been covered, thus expanding the sphere of research from EU ETS, which had been

the prime focus of research in major studies by, for example, Bohringer, Hoffman and

Manrique-de-Lara-Perate (2006), Benz and Trück (2009) and Daskalais, Psychoyios and

Markallos (2009). Second, in this chapter, entire discussion is based on price dynamics of

carbon markets rather than being a mere reflection of the policy and regulatory

perspectives. Finally, not only the CO2 allowance prices, but the prices of certified

emission reductions (CERs) have also been included. This is specifically important, as

CERs are generated from the Clean Development Mechanism (CDM) projects, mainly in

the developing countries. The findings of this chapter suggest that all existing carbon

markets across the EU and North America are not integrated. However, cointegrating

relationships are present within allowance-based markets of North-America.

Cointegration is also observed among the certified emission reduction assets traded in EU

and US, depicting the integration of clean development mechanism project markets.

Allowance-based markets of EU do not show any integration with the North American

carbon markets, requiring policy initiatives on linking the two schemes.

This chapter is organized as follows. Section 3.2 explains the theoretical concepts of

cointegration and empirical estimation. The data set and their time series properties are

described in Section 3.3. Results of Johansen cointegration procedure are reported in

Section 3.4 before policy conclusions and issues of further research are presented in

Section 3.5.

3.2 Theoretical concepts

3.2.1 Cointegration

Cointegration of prices in different markets means that change in price in one market will

lead to change in price in other markets, which means cointegrated markets are not

independent (Shahi, Kant and Yang 2008). Mathematically, a (P X 1) vector of time

series, yt, is co-integrated if each of the elements of yt is I (1), that is, non-stationary with

a unit root, whereas some linear combination of the series a’yt is stationary, or I(0), for

some nonzero (P X 1) vector, a (Engle and Granger 1987). Johansen (1988, 1995) and

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Johansen and Juselius (1990, 1992) have suggested maximum likelihood procedures for

testing of co-integration in a p-dimensional finite-order vector auto-regression (VAR)

model. The procedure gives estimates of system’s co-integrating vectors and their

weights. These estimates are used to test relevant economic hypothesis. Moreover, the

maximum likelihood estimates are symmetrically distributed, median unbiased and have

mixed normal distributions (Johansen 1992). The system of equations is

,1

1 tt

k

i

tit DyAy ε+Φ+=∑=

− ),0(~ Ωpt Nε , Tt ,.....,1= (3.1)

where yt is a vector of empirical variables, Dt is the vector of deterministic terms, which

can contain a constant, a linear trend, seasonal dummies, or other regressors that are

considered fixed or nonstochastic, k is the lag length, εt is a vector of error terms assumed

to be independent identically distributed, i.e., Np (0, Ω), and T is the number of

observations.

Johansen maximum likelihood estimation uses a rank test to define the number of

cointegrating vectors r that can be found in the data. The rank is determined by estimating

the p-dimensional VAR (k) model in Equation (3.1) that can be re-parameterized as a

vector error correction (VEC) model,

ttt

k

i

itt Dyyy ε+Φ+∆Γ+Π=∆ −

=

− ∑ 1

1

1

1 , ),0(~ Ωpt Nε , Tt ,.....,1= (3.2)

where ∆ is the first difference operator, ∆yt is a vector of I(0) processes,

,1

∑+=

−=Γk

ij

ji A

and )(1

∑=

−−=Πk

i

iAI (3.3)

is the matrix of long-run coefficients and can be decomposed as Π=α β’. The matrix α is

the matrix of weights and represents the short-run effect of disequilibria indicating the

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speed of adjustment to the equilibrium. β is the matrix of long-run dynamics of the

variables yt. The columns of β are the co-integrating vectors representing the stationary

linear combination of variables yt. The rank r of the long-run matrix, Π, determines the

number of co-integrating vectors in the system. Johansen (1988, 1995) and Johansen and

Juselius (1990, 1992) have suggested two likelihood ratio-based tests that are called the

trace test and the maximum-Eigenvalue test for testing the rank of Π. Different values for

the number of co-integration vectors have different implications: (1) if the rank of Π is

zero, the variables are not co-integrated and the relationship should be tested using

ordinary least-squares (OLS) in difference (Banerjee et al. 1993, p. 256); (2) if the rank of

Π is full, the series yt are individually stationary and OLS in levels can be used for

testing; (3) if the rank of Π is more than zero and less than the number of variables, the

series yt are co-integrated and the rank indicates the number of linearly independent co-

integrating relations among the variables in yt (Dickey et al. 1991).

3.2.2 Testing for Stationarity and Structural Breaks in time-series

Before using the Johansen’s multivariate co-integration test, it is necessary that all

variables must be non-stationary or integrated of first order, I (1), in the levels and

stationary or I (0) in the first difference. Many unit root tests are available to examine

stationary properties of a time series; each test has high power only under certain

conditions. None of them is universally superior to the others. To obtain reliable

inference regarding the stationary properties of each time-series, three unit root tests are

used: the Augmented Dickey-Fuller (ADF) test, the Phillips-Perron (PP) test, and the

Zivot-Andrews unit root test. The ADF test has been the most commonly used unit root

test (Davidson and MacKinnon 2008). It provides information on whether the variable

under study has some deterministic terms in the regression, which facilitates the

specification of the VEC model. An assumption of the ADF test is that the error terms

follow an AR process of known order. However, when the error terms seem to follow an

MA or ARMA process, in which the moving average polynomial has a large negative

root, the ADF test has low power. Many alternatives to ADF tests have been proposed.

Among the best known are the tests proposed by Phillips and Perron (1988), also called

the PP tests. One of the critical aspects of the ADF and PP tests is a choice of lag length,

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23

k, to eliminate autocorrelation in error terms, and the lag length is selected using Durbin-

Watson test (Wooldridge 2002). A modified ADF test known as Dickey-Fuller

generalized least squares (DF-GLS) de-trending procedure has been proposed by Elliott

et al. (1996), and this test has significantly greater power than the both ADF and PP tests.

In application of this test, we use Swartz minimum information criteria (SMIC) to select

the number of lags. Nevertheless, none of these three tests considers structural breaks that

might have occurred in the time-series. Perron (1989b) has shown that a unit root test that

does not take into account the break in the series will have low power. Thus, to verify the

validity of the ADF, PP and ADF-GLS tests, the Zivot-Andrews unit root test (Zivot and

Andrews 1992) is used to explore the possibility of structural breaks.

3.2.3 Lag length in the VEC Model

The VEC model estimation results are sensitive to the number of lags included in the

model. An inappropriate lag can distort the size of the test and results in loss of power

(Hafer and Sheehan 1991). The Akaike information criterion (AIC) is used to determine

the lag length in the model, which has been proved to outperform the other lag selection

criteria by Chueng and Lai (1993) and Lu¨tkepohl and Saikkonen (1999) using Monte

Carlo simulation.

3.2.4 Testing for Parameter Stability

One of the assumptions of the VEC model is that the parameters like the mean, variance,

and trend remain constant over time. However, if these parameters do not remain

constant over time, it is inferred that a structural break has occurred in the model. Tests

for these changes are known as stability condition tests. Lu¨tkepohl (1993) has suggested

the Eigenvalue test in a VEC model. The test provides an indicator of whether the

number of cointegrating equations is mis-specified or whether the cointegrating equations

are not stationary. If there are p endogenous variables and r cointegrating vectors, there

will be (p-r) unit moduli in the companion matrix and all other remaining moduli are

strictly less than 1, if the model satisfies the stability condition (STATA 2008).

All the estimations and tests in this chapter are performed using STATA/SE version 10.1

computer software.

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3.3 Data Description

Daily price data for the econometric analysis for this chapter is taken from the European

Climate Exchange in Europe Union; from Chicago Climate Exchange, Regional

Greenhouse Gas Initiative and California Climate Action Registry in the USA; and from

Montreal Climate Exchange in Canada. Prices from European Climate Exchange are

available in Euros; from US exchanges in US Dollars; while those from Montreal

Climate Exchange are available in Canadian Dollars. Some transformations of the data

are carried out for analysis. To ensure compatibility between different prices, all prices

have been converted into US$ using daily exchange rates from Federal Reserve Statistical

Release (2010 and 2011). These carbon markets alongwith data sets are described in this

section.

3.3.1 European Climate Exchange (ECX)

European Climate Exchange (ECX) is the platform for carbon trading in European Union

(EU), in which two types of carbon credits (assets) are traded: EU allowances (EUAs)

and Certified Emission Reductions (CERs). Over 100 leading global businesses are

member of ECX emissions products. Trading on the ECX began in April 2005, with

launch of futures contracts. Data for the price series of futures market for both EUA and

CER are used in this chapter.

3.3.2 Chicago Climate Exchange (CCX)

Chicago Climate Exchange (CCX) is a voluntary, legally binding greenhouse gas

reduction and trading system for emission sources and offset projects in North America.

CCX employs independent verification, includes six greenhouse gases, and has been

trading greenhouse gas emission allowances since 2003. CCX has more than 350

members including corporations, educational institutions, and farmers and their

organizations. The commodity traded on CCX, is the Carbon Financial Instrument (CFI)

contract, each of which represents 100 metric tons of CO2 equivalents (CCX 2010). To

carry out empirical analysis, we use futures market prices for both allowances and CERs.

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3.3.3 Regional Greenhouse Gas Initiative (RGGI)

The Regional Greenhouse Gas Initiative (RGGI) is the first mandatory, market-based

effort in the United States to reduce greenhouse gas emissions. Ten Northeastern and

Mid-Atlantic states have capped and decided to reduce 10% CO2 emissions from the

power sector by 2018. States sell nearly all emission allowances through auctions and

invest proceeds in consumer benefits: energy efficiency, renewable energy, and other

clean energy technologies. The initiative envisages spurring innovation in the clean

energy economy and creating green jobs in each state (RGGI 2010). Data for the price

series of futures market for allowance-based assets are used in this chapter. No CERs are

being traded in RGGI.

3.3.4 California Climate Action Registry (CCAR)

The California Climate Action Registry (CCAR) is a program of the Climate Action

Reserve and serves as a voluntary greenhouse gas (GHG) registry to protect and promote

early actions to reduce GHG emissions by organizations by developing and promoting

credible, accurate, and consistent GHG reporting standards and tools for organizations to

measure, monitor, third-party verify and reduce their GHG emissions consistently across

industry sectors and geographical borders. Its members voluntarily measure, verify, and

publicly report their GHG emissions, and are actively participating in solving the

challenge of climate change. The State of California offers its efforts to ensure that

California Registry members receive appropriate consideration for early actions in light

of future state, federal or international GHG regulatory programs (CCAR 2010). Data for

price series of futures market for allowance-based assets are used in this chapter. No

CERs are being traded in CCAR.

3.3.5 Montréal Climate Exchange (MCeX)

The Montréal Climate Exchange (MCeX) provides a market-based solution to help

reducing greenhouse gas (GHG) emissions in Canada. The mission of MCeX is to

provide a transparent and credible marketplace where contracts on GHG emissions are

exchanged. Montréal Climate Exchange is a joint venture between the Montréal

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26

Exchange (MX) and the Chicago Climate Exchange (MCeX 2010). The data from MCeX

is available for futures allowances from May 2007 onwards.

In this chapter, daily price data from all the markets is taken for the period of August

2007 to December 2010. Data notations are described in Table 3.1 and the price series are

shown in Figure 3.1. From the figure, apparently nothing could be said about whether

different markets are integrated or not. However, the price dynamics seem to be similar

among assets within EU and among different assets within North America apart from the

two CER-based assets. However, the long-run and short-run integration is difficult to

infer from just graphical presentation.

Table 3.1. Data description for the price series of carbon markets in EU, USA and

Canada for both Allowance and CER based assets (credits)

Series Description

EUA Price of EU allowances

EUCER Price of EU certified emissions reductions

CCXIA Price of allowances in Chicago Climate Exchange

RGGIA Price of allowances in Regional Greenhouse Gas Initiative

CCXCER Price of certified emissions reductions in Chicago Climate Exchange

MONTLA Price of allowances in Montreal Climate Exchange

CCARA Price of allowances in California Climate Action Registry

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27

CO2 Prices in different Carbon Markets

0.00

10.00

20.00

30.00

40.00

50.00

60.00

1 32 63 94 125 156 187 218 249 280 311 342 373 404 435 466 497 528 559 590 621

Time (Days)

Price (US$)

EUA EUCER CCXA RGGIA

CCXCER CCARA MontrealA

Figure 3.1. Allowance and CER asset prices in carbon markets of EU and North America

3.4 Results and Discussion

3.4.1 Results for Unit Root Tests

The results for unit root tests of ADF and Philips-Peron, for the 7 price series are given in

Table 3.2. Lag selection was made using the Durbin-Watson test. Null hypothesis of a

unit root in the univariate representation cannot be rejected for any of these 7 variables at

5% levels of significance, and each price series becomes stationary after first

differencing. Hence all 7 price series are I (1). The Results of DF-GLS unit-root tests

alongwith lags (selected through Schwert Information Criteria) are provided in Table 3.3

and the results confirm the results of ADF and PP tests that the price series are I(1) . The

results of Zivot-Andrews unit root test, which are also given in Table 3.3, indicate that

the properties of non-stationarity are not affected by structural breaks in any of these

price series, except CCARA, which has a structural break in March 2009. All these tests

are satisfied for all the carbon markets for both allowance and CER based assets. The

only exception is CCARA, which is therefore dropped out in further analysis. There could

be various reasons behind a structural break in CCARA. The State of California has been

quite active to the problem of Climate Change. Under California’s Climate Change

Program, emission reduction targets were set in 2005 and reporting of GHGs was made

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mandatory in December 2007. Further, in December 2008, economy wide cap-and-trade

system was established, apart from implementing a regulation on electrical utilities that

33% of their electricity would be obtained from renewable sources of energy (Nichols

2009). Such policies of the Government in California might have been responsible for

introducing structural breaks in the time-series of prices in CCARA around March 2009.

Table 3.2. Results of ADF and Phillips-Perron unit root tests for carbon prices in the

markets of EU, USA and Canada

ADF Statistics Phillips – Perron Statistics

Z(rho) Z(t) Z(rho) Z(t)

Series Levels Differenced Levels Differenced

EUA -2.872 -43.8** -9.03 -2.11 -1271** -45.3**

EUCER -0.981 -46.8** -20.5 -3.4 -502** -42.6**

CCXA -1.485 -28.2** -5.4 -1.6 -634** -28.1**

RGGIA -2.251 -63.4** -5.6 -2.25 -379** -56.8**

CCXCER -2.611 -28.7** -9.75 -2.62 -315** -27.7**

CCARA -2.42 -31.1** -9.45 -2.22 -222** -36.4**

MONTLA -1.035 -47.3** -1.5 -1.0 -433** -46.6**

The symbol ** indicate 5% significance level

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Table 3.3. Results of DF-GLS and Zivot-Andrews unit-root tests for carbon prices in the markets of EU, USA and Canada

Levels Differenced

Series lags DF-GLS lags DF-GLS Zivot-Andrews

EUA 3 -1.931 3 -14.3** -3.5

EUCER 1 -1.337 3 -3.19** -4.48

CCXA 1 -2.080 8 -3.21** -3.82

RGGIA 2 -2.043 2 -3.99** -4.39

CCXCER 1 -1.860 5 -3.01** -4.35

CCARA 1 -1.99 4 -11.6** -5.28**

MONTLA 1 -1.221 3 -3.5** -3.90

The symbol ** indicate 5% significance level

3.4.2 Carbon Market Integration at international level

Following Shahi, Kant and Yang (2006), the results of Akaike information criteria (AIC)

are used to determine the lag length. AIC chooses lag length j to minimize: log(SSR(j)/n)

+ (j + 1)C(n)/n, where SSR(j) is the sum or squared residuals for the VAR with j lags and

n is the number of observations; C(n) = 2 for AIC (Wooldridge 2002). In STATA 10,

there is a single command that calculates the number of lags, which comes out to be three

in our case.

Using a lag length of three is used for cointegration analysis; the results of Johansen’s

multivariate co-integration test for the number of cointegrating vectors in the 6-

dimensional system are given in Table 3.4. The trace statistics indicate that all six carbon

markets are not integrated.

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Table 3.4. Results of Johansen’s multivariate co-integration tests for the carbon markets

of EU, USA and Canada for both Allowance and CER based credits of EUA, CCXA, RGGIA,

MONTLA, EUCER, and CCXCER (using 3 lags)

No. of co-integrating vectors Trace Statistics Critical value (5%)

r = 0 408.16** 94.15

r ≤ 1 184.51** 68.52

r ≤ 2 51.05* 47.21

r ≤ 3 20.73 29.68

r ≤ 4 6.65 15.41

r ≤ 5 0.65 3.76

The symbol ** indicate 5% significance level

In the next step, tests of co-integration are performed, taking five markets, at a time and

the results are shown in Table 3.5, which shows that even in the groups of five assets, the

markets are not co-integrated. Thenafter, the co-integration tests are performed by taking

four markets, at a time and Table 3.6 indicates the results. Maximum rank of 2 for the

four allowance-based assets (shown as bold letters in Table 3.6) depicts that even four

carbon markets of Allowance-based assets are not integrated. All these results, therefore

indicate that the LOP does not exist across the combined carbon markets of EU and

North America.

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Table 3.5. Results of Johansen’s multivariate co-integration tests for carbon

markets of EU, USA and Canada for both Allowance and CER based credits of

EUA, CCXA, RGGIA, MONTLA, EUCER, and CCXCER, taking five assets at a time (using

3 lags)

Group of five assets, tested for co-integration Maximum Rank

CCXA, RGGIA, MONTLA, EUCER, and CCXCER 3

EUA, RGGIA, MONTLA, EUCER, and CCXCER 2

EUA, CCXA, MONTLA, EUCER, and CCXCER 2

EUA, CCXA, RGGIA, EUCER, and CCXCER 2

EUA, CCXA, RGGIA, MONTLA and CCXCER 1

EUA, CCXA, RGGIA, MONTLA, and EUCER 1

Table 3.6. Results of Johansen’s multivariate co-integration tests for carbon markets of EU,

USA and Canada for both Allowance and CER based credits of EUA, CCXA, RGGIA, MONTLA,

EUCER, and CCXCER, taking four assets at a time (using 3 lags)

Group of four assets,

tested for co-integration

Maximum Rank Group of four assets,

tested for co-integration

Maximum Rank

CCXA, MONTLA, EUCER, and

CCXCER

2 EUA, RGGIA, EUCER, and

CCXCER

1

CCXA, RGGIA, EUCER, and

CCXCER

1 EUA, CCXA, EUCER, and

CCXCER

1

CCXA, RGGIA, MONTLA,

and CCXCER

1 EUA, CCXA, RGGIA and

CCXCER

1

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CCXA, RGGIA, MONTLA and

EUCER

2 EUA, CCXA, RGGIA and

EUCER

2

RGGIA, MONTLA, EUCER,

and CCXCER

2 CCXA, RGGIA, MONTLA

and CCXCER

1

EUA, MONTLA, EUCER, and

CCXCER

2 EUA, RGGIA, MONTLA and

CCXCER

2

EUA, RGGIA, EUCER, and

CCXCER

1 EUA, CCXA, MONTLA and

CCXCER

1

EUA, RGGIA, MONTLA, and

CCXCER

1 EUA, CCXA, RGGIA and

CCXCER

1

EUA, RGGIA, MONTLA, and

EUCER

2 EUA, CCXA, RGGIA and

MONTLA

2

CCXA, MONTLA, EUCER, and

CCXCER

2 CCXA, RGGIA, MONTLA,

and EUCER

1

EUA, MONTLA, EUCER, and

CCXCER

1 EUA, RGGIA, MONTLA, and

EUCER

1

EUA, CCXA, EUCER, and

CCXCER

2 EUA, CCXA, MONTLA, and

EUCER

2

EUA, CCXA, MONTLA and

CCXCER

1 EUA, CCXA, RGGIA and

EUCER

1

EUA, CCXA, MONTLA and

EUCER

1 EUA, CCXA, RGGIA and

MONTLA

2

Going a step further, the co-integration tests are performed by taking combinations of

three markets at a time. The results show that even in the groups of three, most markets

are not co-integrated. The only exceptions in this case are three allowance-based markets

of North America - CCXA, RGGIA and MONTLA are co-integrated, the results of which

are given in Table 3.7.

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Table 3.7. Results of Johansen’s multivariate co-integration tests for only Allowance-

based credits of CCXA, RGGIA and MONTLA in North America only (using 3 lags)

No. of co-integrating vectors Trace Statistics Critical value (5%)

r = 0 30.12* 29.68

r ≤ 1 15.95* 15.41

r ≤ 2 4.77* 3.76

The stability of this VEC model for North American markets is tested using Lütekpohl

Eigenvalue stability tests, the results of which are shown in Figure 3.2. The VEC model

specification imposes 1 unit modulus, and the rest of the moduli are strictly less than 1.

Therefore VEC is stable for the three allowance-based assets of North American markets

and hence the results of cointegration test for North American markets are robust.

-1-.5

0.5

1Imaginary

-1 -.5 0 .5 1Real

The VECM specification imposes 1 unit modulus

Roots of the companion matrix

Figure 3.2. Graph of structural stability tests using Eigenvalue

stability condition in VEC model for Allowance-based assets

CCXA, RGGIA and MONTLA in North America

Lastly, the co-integration tests are performed by taking combinations of two assets at a

time. The results from these tests indicate that that most of the carbon markets are not co-

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integrated in pairs. The only exceptions are the CER markets of EU and Chicago Climate

Exchange (EUCER, and CCXCER,) which are integrated. Hence, the results of Johansen’s

multivariate co-integration tests for CER-based credits only for both the markets of EU

and North America are given in Table 3.8.

Table 3.8. Results of Johansen’s multivariate co-integration tests for carbon markets of

EU and North America for CER-based credits EUCER and CCXCER (using 3 lags)

No. of co-integrating vectors Trace Statistics Critical value (5%)

r = 0 17.20* 15.41

r ≤ 1 7.09* 3.76

The stability of this VEC model for CER-based assets in carbon markets is also tested

using Lütekpohl Eigenvalue stability tests, the results of which are shown in Figure 3.3.

The VEC model specification imposes 1 unit modulus, and the rest of the moduli are

strictly less than 1. Therefore VEC is stable for the two allowance-based markets of the

EU and CCX, and hence the results of cointegration test these markets are robust.

In fact, the data for the two CER markets are available since 2005. Hence, for these two

markets Johansen’s cointegration test was also conducted for the entire period, and the

markets were found to be cointegrated during this entire period.

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-1-.5

0.5

1Imaginary

-1 -.5 0 .5 1Real

The VECM specification imposes 1 unit modulus

Roots of the companion matrix

Figure 3.3. Graph of structural stability tests using Eigenvalue

stability condition in VEC model for CER-based assets

EUCER, and CCXCER in EU and North America

3.4.3 Long-run relationships of prices

The long-run relationship of prices among the co-integrated markets is defined by the

cointegrating vector β obtained from the Johansen cointegration test corresponding to the

highest Eigenvalues. The normalized coefficients α represent the weights or adjustment

coefficients that measure the average speed of adjustment toward the long-run

equilibrium, and a high value of α indicates rapid adjustment toward equilibrium

(Hänninen 1998). Since co-integration is observed among allowance-based North

American carbon markets; and also between CER-based EU and North American carbon

markets, the long-run relationships are compared among these two sets of co-integrated

markets. The long-run equilibrium relationship for allowance-based assets of North

American carbon markets CCXA, RGGIA and MONTLA is found to be:

RGGIA = 0.00005 CCXA – 0.75 MONTLA – 0.26 (3.4)

With the corresponding α values of weighting matrix as given below:

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0.056 CCXA – 0.017 RGGIA + 0.037 MONTLA (3.5)

The β values in equation (3.4) indicate that in long-run equilibrium any increase in prices

in Chicago Climate Exchange will lead to a negligible increase in prices in Regional

Greenhouse Gas Initiative carbon market but an increase in prices in Montreal Climate

Exchange will have a significant negative effect on the prices in Regional Greenhouse

Gas Initiative market. In other words, in long-run equilibrium, a 1% increase in price of

allowances in RGGI market is accompanied by almost negligible price change in

allowance prices in CCX, keeping price in Montreal fixed; and a 1% increase in price of

allowances in RGGI market is accompanied by 0.75% decrease in prices of allowances-

based assets in Montreal Climate Exchange, keeping price in CCX fixed.

The values of α in weighting matrix (3.5) represent the speed of adjustment of each

variable toward the long-run equilibrium and measure the feedback effect of

disequilibrium in cointegrating relation on vectors in auto-regression. The coefficients in

weighting matrix show the slow adjustment of prices in RGGI towards long-run

equilibrium state, followed by Montreal exchange and fastest adjustment of prices in

Chicago Climate Exchange. The negative coefficient of RGGIA further implies that a

positive excess of long-run equilibrium induces a lower change in price of RGGIA (He,

Wang and Lai 2010).

Similarly, the long-run relationship defined by the cointegrating vector corresponding to

highest Eigenvalue for CER-based assets of EU and North American carbon markets

EUCER, and CCXCER is represented by

EUCER = 1.16 CCXCER – 35.9 (3.6)

With the corresponding α values of weighting matrix as

- 0.012 EUCER - 0.020 CCXCER (3.7)

The β values in equation (3.6) indicate that in long-run equilibrium, a 1% increase in

price of CERs in EU market is accompanied by 1.16% price increase in CER prices in

CCX, which indicates that the CER sellers in CCX are put in more advantageous position

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as compared to their EU counterparts. However the values of α in weighting matrix (3.7)

show faster adjustment of prices of CER assets towards long-run equilibrium state in

Chicago Climate Exchange as compared to the EU market.

3.5 Summary and Conclusions

After the initiation of the EU Emission Trading Scheme (EU ETS) in 2005, several

carbon markets are now emerging world-wide, e.g. in the USA, Australia, New Zealand,

Canada, Japan and Switzerland. Integration of regional and international markets has

been proposed as one option to strengthen economic efficiency and politically reinforce

the international emissions trading regimes (for example Stern 2007, 2008; Edenhofer et

al. 2008; Garnaut 2008). The main objective of this chapter is to draw some inferences

for knowing market efficiency in carbon trading and linking different schemes and

markets, depending on the price dynamics in world’s carbon markets. In this chapter, the

Law of one price (LOP) is tested among different carbon markets of EU and North

America for both allowance and CER-based assets: CCXA, RGGIA, MONTLA, CCARTA,

EUCER and CCXCER using Johansen’s multivariate cointegration test.

The results indicate first of all that LOP does not exist as such among all the carbon

markets of EU and North America. This result is evident from all the cointegration tests

performed in this chapter, taking combinations of six, five and four assets at a time. Even

the CO2 allowance markets across the Atlantic are not integrated. This implies that the

effects of inter-continental allowance-based trade in carbon markets are limited; and thus

the market power of regional credit suppliers is large. This has particular implications for

the European carbon market, faced with a narrow oligopoly of suppliers, where strict

compliance may have weakened the bargaining power of the buyers. There could be

various reasons behind these results. First of all, allowance-prices in North America are

determined in a different manner from EU due to non-fixation of targets by the American

and Canadian Governments so far, than the prices in Kyoto compliant European Carbon

market. Carbon markets in North America are of voluntary nature so far. The agents

involved in these markets trade in carbon markets purely on account of their

environmental responsibility behavior, as contrasted to agents in EU markets, who are

mandated by law to fix emissions at a particular level. In addition, the Marrakesh

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Accords allow only Kyoto signatory countries to use allowances from each other for

compliance purposes (Persson 2009) and EU Directive of 2003 makes clear that EU ETS

can be linked only with Kyoto compliance countries. Due to the fact that USA is not a

Kyoto-signatory so far, such link cannot be established and hence the two markets are not

cointegrated. Hence an overall inefficiency is introduced in the system and emissions

cannot be reduced at the least possible cost. An important policy intervention could be to

allow establishing links between different countries, irrespective of their Kyoto

commitments, so as to find a minimum cost solution to tackle climate change.

Second, a strong evidence for the regional market integration for allowance-based assets

is found in North American carbon markets. It shows a presence of regional effect in

North American carbon markets. The phenomenon could be possibly due to spatial

proximity of the markets with each other. In addition, the existence of cointegration

among the markets implies a common stochastic trend in those markets (Kasa, 1992; Jang

and Sul, 2002). Since each North American allowance market price series contains

information on the common stochastic trends (which bind all these markets together), the

predictability of one carbon market’s prices can be enhanced significantly by utilizing

information on the other market’s prices. The presence of common stochastic trends

among all these markets implies that once new information on carbon price in one market

is available prior to other markets’ prices, the other markets’ prices will deviate from that

trend through a transitory component (Masih & Masih, 1999). As traders in all these

markets have perfect information about all these markets, their transaction costs become

equal for trading in either of them.

Third, in the co-integrating vector of North-American markets, the coefficient of

Montreal Exchange prices is negative while the coefficients of the two US markets are

positive. This may be an indication of switching of some buyers, specifically Canadian

buyers, from the US markets to the Canadian market. In the beginning, when the

Montreal exchange was not established, the Canadian firms were trading in Chicago

exchange, and after the establishment of Montreal exchange these firms have an option to

trade either in the Canadian or US markets. Hence, the total demand is divided between

these two markets. In the long-run equilibrium, therefore, if more firms trade in the US

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markets (which means increase in prices in the US markets), the Canadian market will

face less demand and therefore prices will decrease or vice-versa.

Fourth, a very striking finding of this chapter is that the Certified Emission Reduction

(CER) markets in Europe and USA are integrated. This could be explained by the fact

that the CER credits are generated mainly by the Clean Development Mechanism (CDM)

projects, primarily in the developing countries and irrespective of the trading countries;

their prices show co-movement around the world. It also indicates the efficiency of CDM

projects and existence of a global market for CDM under the overall carbon trading

process. However, there is a world of caution for the future. The types of projects

qualifying for availing CERs in Europe and in Chicago market are not similar. For

example, offsets generated from Forestry sector qualify in CCX, but not in EU market for

compliance purposes (ECX 2009 and CCX 2009). So situation in CER market might

change in future, if attempts are not made either to link or to make both the markets

homogenous with respect to type of projects. Nonetheless, the development of global

carbon market for CDM can be seen as one manifestation of improved expectations for

ensuring carbon sequestration and sustainable development in developing countries. To

confirm these expectations, the Annex-I countries should continue to improve the

investment environment and enhance incentives for these projects in the developing

world.

Fifth, these findings also indicate that most likely new carbon markets created in different

parts of the world such as Australia, Singapore, and other countries, will not be co-

integrated because each of these markets will be governed by a different set of

institutional arrangements and there will be restrictions on participation of buyers from

other countries and regions. The possibilities of arbitrage across the global markets will

be limited, and the carbon trading in these markets will be globally inefficient. Hence,

there is a strong need of a global agreement that allows global carbon trade to prevent

climate change at the least cost options.

Finally, this chapter is a first attempt on exploring integration of carbon markets using

price dynamics. Inspite of the new findings, the study, however, is not free from various

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limitations. For example, the number of co-integrated markets is not a true measure of the

degree of market integration; that can be only assessed by measuring the reaction time to

remove disequilibria from the cointegrating relationships. Similarly, Johansen’s

multivariate cointegration procedure does not take into account the transaction costs, the

marginal abatement costs and other charges associated with carbon trading; and therefore

is not a very reliable method for analyzing the efficiency of arbitrage between the two

markets. In addition, only univariate price equations have been considered, whereas,

volume of trading can also be taken into account while exploring market integration.

Future research should include more assets from other carbon markets of the world and

the enhanced aspects of market integration. New research should not only confirm or

contradict the present results, but also try to resolve such issues by using further

econometric analysis and looking at more recent developments in the international carbon

markets using more extensive data series coming from newly emerging carbon markets.

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4 Forecasting volatility of carbon markets

ABSTRACT

Market volatility plays a big role for investments in carbon portfolios and can be an

important input into macro-econometric models and calculation of value-at-risk. This

chapter evaluates the performance of various econometric models, both simple and

complex, for predicting short-term price volatility in European Climate Exchange (ECX)

and Chicago Climate Exchange (ECX). Despite various policy level changes in emission

trading mechanisms, volatility in the two carbon markets follows a stationary pattern and

hence can be forecasted. Voluntary carbon market of CCX is relatively more volatile and

is forecasted best by complex model like non-linear GARCH; and the behavior of this

voluntary market is similar to that found in other financial markets and energy markets.

The compliance market of ECX, on the other hand, is less volatile and is forecasted best

by simple econometric models like Historical Averages and GARCH (1, 1) and hence is

different from both compliance markets and other financial markets. Findings of this

chapter could be useful in making decisions in carbon portfolio investments by

individuals and firms; and for making choice between various policy instruments at the

strategic level.

Key words: carbon market; climate change; price; volatility; forecasting; econometric

model

4.1 Introduction

Carbon markets around the world have witnessed a big growth in the recent past. The

markets continue to grow year after year, reaching about US$ 122 Billion in 2009, which

is over 12 times their 2005 value (World Bank 2010). This new market system represents

a shift in paradigms, since environmental policy has historically been a command-and-

control type regulation where companies are required to comply with emission standards

or implement particular technologies. At the recent Copenhagen and Cancun meets of the

United Nations Framework Convention on Climate Change (UNFCCC), it has been

decided by the international community to pursue carbon market approach to enhance the

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cost-effectiveness and to promote mitigation actions for curbing climate change (CoP,

2010). There are two major types of carbon markets: compliance (or regulatory) markets

and voluntary markets. Compliance markets are created and regulated by mandatory

regional, national, and international carbon reduction regimes. Voluntary carbon markets

function outside of the compliance markets, enabling companies and individuals to

purchase carbon offsets on a voluntary basis. A voluntary market reflects the sum of all

transactions of carbon credits and allowances, where the final purpose of cancelling or

retiring the carbon credit is not to comply with legislation or to fulfill agreements

between companies and governments (Capoor and Ambrosi 2009).

Due to establishment of carbon markets, the right to emit a particular amount of carbon

dioxide (CO2) has become a tradable commodity. By requiring the emitters to hold an

adequate stock of allowances that corresponds to their CO2 output, carbon markets

provide new business development opportunities for market intermediaries and service

providers. The price behavior and dynamics of this new asset class, the carbon credits,

has acquired a lot of importance (Benz and Trück 2009). Risk management consultants,

brokers, carbon procurement funds and hedge fund managers and other buyers are

scouring the globe for opportunities to buy carbon credits (Labbat and White 2009).

Despite their voluminous growth, carbon markets, however, have experienced a lot of

fluctuations since their very inception, which are caused by the market uncertainties.

Because supply, demand, and regulatory conditions evolve unpredictably over time,

regulations based on fixing emission levels are causing a lot of volatility in market price

of carbon. The history of European trading prices for CO2 illustrates the extreme

volatility of carbon markets, for example during 2006 itself, the range of trading prices

varied from $44.47 to $143.06 per ton carbon (Capoor and Ambrosi 2009). Therefore a

lot of insight could be gained by looking into the functioning of carbon markets by

examining their historical volatility.

Volatility measures the average absolute daily change, and is a common approach to

indicate the variability and unpredictability of the price of a tradable commodity

(Nordhaus 2007). For carbon markets, in particular, a full understanding of volatility of

carbon prices is critical from multiple perspectives. First, price volatility could

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discourage the deployment of new capital intensive abatement technologies, by giving

rise to an option value from delaying irreversible investments (Chao and Wilson 1993).

Second, for most of the investment decisions, volatility shall determine the return on

capital. For example for an electric utility deciding whether to install carbon capture and

storage (CCS) technology, the return from initial capital cost of CCS will depend on the

expected variable costs of capturing and storing carbon, relative to reducing emissions by

fuel-switching or demand-side management. Third, price volatility may have some major

disruptive effects on the price dynamics of the market. For stability, it is imperative to

limit price volatility by allowing banking or borrowing of carbon credits for future use,

setting price floors and ceilings or linking various carbon trading schemes together

(Brohe et. al. 2009, 51-53). Lastly, forecasts of carbon price volatility could be important

inputs into macro-econometric models and market risk assessment calculations. Price

volatility, therefore, is one of the key factors in the choice of a carbon policy instrument.

Recently, a large volume of literature has emerged on modeling and forecasting volatility

in financial markets. Most of this research has focused on equity or foreign exchange

markets (for example, Bollerslev 1986; Akgiray 1989; Pagan and Schwert 1990;

Brailsford and Faff 1996; Yu 2002; Brooks and Persand 2002, 2003). A general

consensus from this literature is that generalized autoregressive conditional

heteroskedastic (GARCH) models and their variants tend to work better, over different

series and data frequencies, as compared to other techniques like moving average,

exponential smoothing and linear regression for such markets. Kang, Kang and Yoon

(2009) investigate the efficacy of volatility forecasting models for three crude oil

markets, and found advanced GARCH models more useful. Sadorsky (2006) also proves

the same for heating oil and natural gas volatility. For carbon markets, most of research is

focused on modeling price behavior rather than volatility. Benz and Trück (2009) analyze

the short-term price behavior of carbon dioxide (CO2) emission allowances of the EU

emissions trading system (EU ETS). They suggest the use of Markov switching and AR–

GARCH models for stochastic price modeling. Seifert, Uhrig- Homburg and Wagner

(2008) investigate the success chances and optimal design of derivatives on emission

allowances and develop a stochastic equilibrium model reflecting in a stylized way the

most important features of the EU ETS and analyze the resulting price dynamics. Their

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main findings are that an adequate CO2 process does not necessarily have to follow any

seasonal patterns. Paolella and Taschini (2006) provide an econometric analysis

addressing the unconditional tail behavior and the heteroskedastic dynamics in the returns

on CO2 and SO2 allowances. Daskalakis, Psychoyios and Markellos (2005), in their study

on emission allowance prices and derivatives, argue that market participants adopt

standard no-arbitrage pricing. A major gap in this carbon market literature is that all these

studies focus primarily on the European carbon market and even for that the specific

focus is on price, rather than volatility.

In this chapter, out-of-sample performance of various econometric models is assessed for

forecasting volatility in carbon markets of European Climate Exchange (ECX) and

Chicago Climate Exchange (CCX). Volatility forecasts are evaluated using different

approaches. The purpose is to compare the performance of eight econometric models

with regard to their ability to identify and forecast the price volatility in both compliance

and voluntary markets. The chapter contributes to the existing literature in three major

aspects. First, both compliance market of ECX and voluntary market of CCX have been

studied, thus expanding the sphere of research which had been primarily focused on ECX

so far. Second, future and option markets of carbon are also studied in addition to spot

markets. Since futures and options rather than spot prices are likely to be held for

investment purposes (Daskalkis, Psychoyios and Markellos 2009), it becomes all the

more important to carry out their study. Finally, instead of concentrating just on the price

of carbon credits, the primary objective of this chapter is to forecast volatility.

The chapter is organized as follows. Section 4.2 describes the theory of volatility in

carbon markets. Section 4.3 outlines the econometric models used in this paper for

volatility forecasts. Tests for stationarity and structural breaks are described in section

4.4. Evaluation measures used to assess the performance of the candidate models are

presented in Section 4.5. Section 4.6 describes the data set used in this chapter. Section

4.7 describes the empirical results and Section 4.8 gives summary and conclusions.

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4.2 Volatility in carbon markets

Following an approach similar to that of Burtraw (1996), the principle driving factors of

volatility in carbon market prices can be categorized into (i) policy and regulatory issues

and (ii) market fundamentals that directly concern the production of CO2 and thus

demand and supply of carbon credits. Changes in policy directives or regulations may

have substantial consequences on the long-term price behavior of market volatility. In the

carbon market these could be decisions and announcements concerning allowance

allocation plans or change of national emission caps. Hence, the consequences of changes

in such regulatory or policy issues may be sudden price jumps, spikes or phases of

extreme volatility in allowance prices. For example, long-run volatility in the EU ETS in

2006–2007, during the program’s pilot phase, arose from an oversupply of allowances

along with the failure to allow banking (Keohane 2009). However, we have not

incorporated long-run volatility in our econometric models, as focus of this chapter is

only on the short-term volatility behavior, which is affected by market fundamentals that

directly concern the production of CO2 and thus demand and supply of carbon credits. It

could also be affected by certain design features and trends in other carbon markets (Benz

and Trück 2006). It is the challenge of an appropriate stochastic model, therefore, to

capture short-run volatility patterns in carbon markets. The most common measure of a

short-term volatility is daily market volatility. In the literature there are a number of ways

to obtain daily volatility series. The daily returns on day t are defined as the natural

logarithm of price relatives (Merton 1980 and Perry 1982); that is

1

log−

=t

tt

P

Pr (4.1)

where tP is the daily price of Carbon in any of these markets. The daily market volatility

is defined as the squared daily returns (Sadorsky 2006), that is, Daily Volatility

22

tT r=σ (4.2)

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4.3 Econometric Models used to test Volatility

We use eight models for the purpose of forecasting the above described daily volatility of

carbon markets.

4.3.1 Random Walk

The random walk model is the simplest possible econometric model and is defined as

22

tt σσ =+ (4.3)

hence it is assumed that the best forecast of next day’s volatility is today’s volatility.

4.3.2 Historical average

If the conditional expectation of volatility is assumed to be constant, the optimum

forecast of future volatility would be the historical average, that is

2

1

2

1 /1ˆt

T

tt T σσ ∑ =+ = (4.4)

Here T is the number of days since beginning of trading of a particular carbon asset. This

is the model used most often in the past to predict volatility.

4.3.3 Moving averages

According to the historical average model, all past observations receive equal weight. In

the moving average model, however, more recent observations receive weight. In this

chapter, a 400-day moving average model is used. The model is defined as

2

1

400

1

2

1 400/1ˆjtjt −+=+ ∑= σσ (4.5)

4.3.4 OLS regression

This is one-step ahead forecast based on the simple OLS regression of the volatility on

day t+1 on the volatility at day t. The expression is given by

2

21

2

tt σββσ +=+ (4.6)

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4.3.5 Autoregressive conditional heteroskedasticity (ARCH)

The basic idea of ARCH models (Engle 1982) is that the square of the error term at time t

depends on the realized values of the squared error terms in previous time periods

(Davidson and McKinnon 2004). The model ARCH (q) is defined by

tttr εσ= ; ∑=

−− +=Ω≡q

i

itittt uuE1

2

01

22 )( αασ (4.7)

where αi > 0 for all i=0,1,……….., q. Here εt is white noise with variance 1 and q is the

previous time-periods to be considered for error terms. Here, analysis is done for ARCH

(1) model. Using first observations, the parameters α0 and α1 are calculated and then daily

volatility forecast for 2

tσ is calculated using

2

110

2 ˆˆ−+= tt rαασ (4.8)

4.3.6 Generalized autoregressive conditional heteroskedasticity (GARCH)

A major drawback of ARCH models is that they do not consider the dependence of

variance on the variance of previous time-periods. Hence generalized ARCH model,

proposed by Bollersev (1986), is used instead of the original ARCH model (Davidson

and McKinnon 2004). GARCH (p, q) process is defined as

tttr εσ= ; ∑∑ = −

=

−− ++=Ω≡p

j jtj

q

i

itittt uuE1

2

1

2

01

22 )( σδαασ (4.9)

where 1⟨+ δα and δj > 0 for all j=0,1,….p. Here p is the previous time-periods to be

considered for variance. GARCH (1, 1) model has been found to be adequate in many

applications (Yu 2002) and hence is used here as a candidate model. In this model, first

the parameters α0, α1 and δ1 are estimated and then daily volatility forecast for 2

tσ is

estimated using

2

11

2

110

2 ˆˆ−− ++= ttt u σδαασ (4.10)

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4.3.7 Asymmetric GARCH

Asymmetric GARCH models (Hentschel 1995) incorporate the asymmetric impacts of

shocks or news of equal magnitude but opposite sign on the conditional variance of asset

returns. Various asymmetric GARCH models are available. Quadratic-GARCH model, of

Sentana (1995) has been used here, which is defined as

tttr εσ= ; ∑∑∑ = −= −

=

−− +++=Ω≡q

i iti

p

j jtj

q

i

itittt uuuE11

2

1

2

01

22 )( ωσλαασ (4.11)

With respect to the simpler GARCH(1,1) model, only the term ut-1 is added, which allows

for the asymmetric impact of positive and negative shocks. The asymmetry of the impact

varies as the dimension of the shock varies; in particular the asymmetric impact decreases

as the dimension of the shock increases. If ω is negative, the impact of negative shocks is

larger than the impact of positive shocks. Since the index of kurtosis for ut is a positive

function of the module of ω, this asymmetric-GARCH model is able to rationalize excess

kurtosis in returns coming from investments in carbon markets. Like in GARCH (1, 1)

model, first the parameters α0, α1 and λ1 and ω1 are estimated and then daily volatility

forecast for 2

tσ is esimated using

tttt uu 1

2

11

2

110

2 ˆˆ ωσλαασ +++= −− (4.12)

4.3.8 Non-linear GARCH

In practice the simple GARCH (1, 1) model has been by far the most commonly used

model for conditional variance. However, in many cases it has been found that estimates

obtained for the parameters α and δ are such that their sum is relatively close to unity and

hence the stationarity condition α + δ < 1 is nearly violated. Models of this kind are often

undesirable because they can exaggerate volatility persistence and, consequently, result in

relatively poor volatility forecasts. Therefore, we shall consider nonlinear alternatives of

the conventional GARCH model, such as N-GARCH (1, 1), which is given below:

tttr εσ= ; 2

11

2

111

2

1101

22 )()( −−−− +++=Ω≡ tttttt HuuE σδσβαασ (4.13)

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Where α1>0 and H1 is increasing function. In applications the function H1 depends on

parameters and it is supposed to be similar to the cumulative distribution function of a

positive continuous random variable. In this chapter, this is taken as a second order

quadratic function.

4.4 Testing for Stationarity and Structural Breaks

Before testing for complex econometric models like ARCH, GARCH and non-linear

models it is necessary that volatility variable must be stationary (Yu 2002). Many unit

root tests are available to examine stationary properties of a time series; each test has

high power only under certain conditions and none of them is universally superior to the

others. To obtain reliable inference regarding the stationary properties of each time-

series, we use three unit root tests: the Augmented Dickey-Fuller (ADF) test, the Phillips-

Perron (PP) test, and the Zivot-Andrews unit root test. The ADF test has been the most

commonly used unit root test (Davidson and MacKinnon 2004). An assumption of the

ADF test is that the error terms follow an AR process of known order. However, when

the error terms seem to follow an MA or ARMA process, in which the moving average

polynomial has a large negative root, the ADF test has low power (Schwert 1989). An

alternative to ADF is the test proposed by Phillips and Perron (1988), also called the PP

test. One of the critical aspects of the ADF and PP tests is a choice of lag length, k, to

eliminate autocorrelation in error terms, and in this study Durbin-Watson test

(Wooldridge 2002) is used to select the lag length. A modified ADF test known as

Dickey-Fuller generalized least squares (DF-GLS) de-trending procedure has been

proposed by Elliott et al. (1996), and this test has significantly greater power than the

both ADF and PP tests. In application of this test, Swartz minimum information criterion

(SMIC) is used to select the number of lags. Nevertheless, none of these three tests

considers structural breaks that might have occurred in the time-series. Perron (1989b)

has shown that a unit root test that does not take into account the break in the series will

have low power. Thus, to verify the validity of the ADF, PP and ADF-GLS tests, the

Zivot-Andrews unit root test (Zivot and Andrews 1992) is used to explore the possibility

of structural breaks.

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4.5 Evaluation Measures

Three measures are used to evaluate the forecast accuracy. In addition to common

assessment measure as the Root Mean Square Error (RMSE) two other measures: the

Theil-U statistic and the LINEX loss function are also employed to evaluate the forecast

accuracy. The additional advantage of using Theil-U statistic is that it is invariant to any

linear transformation (Armstrong and Fildes 1995). The LINEX loss function has an

additional advantage that it is asymmetric and hence can evaluate positive errors more (or

less) than negative errors (Christofferson and Diebold 1987). Another reason for the

popularity of LINEX function is that it provides the analytical solution for the optimal

prediction under conditional normality (Yu 2002). The evaluation measures are defined

as

4.5.1 Root mean square error (RMSE)

RMSE = ∑=

−I

i

iiI 1

222 )ˆ(1

σσ (4.14)

4.5.2 Theil-U statistic

Theil-U = 22

1

2

1

1

222

)(

)ˆ(

i

I

i

i

I

i

ii

σσ

σσ

= (4.15)

4.5.3 LINEX loss function

LINEX = ]1)ˆ()ˆ([exp1 2222

1

−−+−−∑=

iiii

I

i

aaI

σσσσ (4.16)

Where a in the LINEX loss function is a given parameter. In the LINEX loss function,

positive errors are weighed differently from the negative errors. If a>0, the LINEX loss

function is almost linear for 0ˆ 22 >− tt σσ (over-predictions) and exponential for

0ˆ 22 <− tt σσ (under-predictions). Thus negative errors receive more weight than the

positive errors. In the context of volatility forecasts, this implies that an under-prediction

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of volatility needs to be taken into consideration more seriously (Yu 2002). Similarly,

negative errors receive less weight than positive errors when a<0. In this chapter, two

values of a are used, namely, 20, and -20.

4.6 Data

For the compliance carbon market, data has been taken from the European Climate

Exchange (ECX), which is the trading platform for EU ETS. The ECX is the leading

market for trading CO2 emissions in Europe that allows the EU allowances (EUAs)

trading for spot, futures and options markets. Volatility study for the spot market of the

ECX has already been done by Benz and Trück (2009), and therefore this chapter focuses

on the futures and options markets only. For the ECX futures market, the data sample

consists of daily returns over the period from March 2006 to July 2009. The data for the

ECX Options market consists of daily returns over the period from October 2006 to July

2009. The data for voluntary market is taken from the Chicago Climate Exchange (CCX),

which is North America’s only voluntary market for offset projects. The CCX employs

independent verification, includes six greenhouse gases, and has been trading greenhouse

gas emission allowances since 2003. The commodity traded on CCX is the Carbon

Financial Instrument (CFI) contract, each of which represents 100 metric tons of CO2

equivalents. The CFI contracts are comprised of Exchange Allowances and Exchange

Offsets. Exchange Allowances are issued to emitting members in accordance with their

emission baseline and the CCX Emission Reduction Schedule. Exchange Offsets are

generated by qualifying offset projects (CCX 2010). To draw comparison with the

results of the EU spot market from Benz and Trück (2009), this chapter focuses on only

spot market of the CCX. The CCX data consists of daily returns over the period from

December 2003 to July 2009.

4.7 Results

The results of our analysis are divided into graphical analysis, stationarity analysis, and

volatility analysis and are given subsequently.

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4.7.1 Graphical analysis

For the ECX Options market, the daily carbon prices are plotted in Figure 4.1, and daily

price volatility in Figure 4.2. From figure 4.2, we can observe that the ECX Options

market remained stable from its beginning in October 2006 to June 2008 and then

became volatile from July 2008 to July 2009. The increase in volatility after 2008 might

be due to beginning of the first commitment period of the Kyoto Protocol (2008-2012).

Fig.4.1. Price in ECX Options Market,

Oct. 2006 to Jul. 2009

Fig.4.2. Volatility in ECX Options

Market, Oct. 2006 to Jul. 2009

For the ECX Futures market, the daily carbon prices are plotted in Figure 4.3 and daily

volatility in Figure 4.4.

Fig.4.3. Price in ECX Futures Market,

Mar. 2006 to Jul. 2009

Fig.4.4. Volatility in ECX Futures Market,

Mar. 2006 to Jul. 2009

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It is apparent from comparison of figures 4.2 and 4.4 that the trends of volatility in the

ECX Futures market were quite different from the ECX Options market.

Looking at the data from Chicago Climate Exchange (CCX), which is a voluntary

market, we have volatility data from December 2003 to July 2009. The daily variation of

the carbon price is plotted in Fig. 4.5 and the corresponding volatility in Fig. 4.6.

Fig.4.5. Price in CCX, Dec. 2003 to Jul.

2009

Fig.4.6. Volatility in CCX, Dec. 2003 to

Jul. 2009

From figure 4.6, it is apparent that ups and downs in the volatility of the CCX spot

market are altogether different from the ECX market. Apparently, there are three periods

of distinct volatility. CCX spot market remained highly volatile from December 2003 to

April 2006, possibly because it was a new market and then again volatility was high from

January 2008 to July 2009. In between these two periods, market was more or less stable.

Though the graphical analysis tells us about different volatility patterns, it does not

extend any help for the purpose of forecasting volatility in these markets. Hence we need

to look at the mathematical models to serve this purpose. But before doing that it is

necessary to see if these volatility series are stationary or are having structural breaks, as

depicted by graphical analysis.

4.7.2 Stationarity analysis

The above preliminary analysis of short-term volatility in the two carbon markets of ECX

and CCX shows that the nature of volatility in different markets is different and hence

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needs different econometric models to explain. Before modelling such volatility for these

markets, we shall first have a look at the summary statistics of our data samples. Table

4.1 shows the mean, median, maximum, kurtosis and first four autocorrelations ρ1, ρ2, ρ3

and ρ4 of the entire sample for different carbon markets. The mean and median values of

volatility depict that CCX market remained more volatile as compared to its European

counterparts. Kurtosis values are very high for all the markets, which mean that the

unconditional distribution of volatility is not a normal distribution. Table 4.1 shows that

for all these markets, while higher order autocorrelations are in general diminishing, the

first autocorrelation is low but not negligible.

Table 4.1. Summary statistics of the volatility series and tests for non-stationarity for ECX and CCX

Carbon

Asset Mean Median Maximum Kurtosis ρ1 ρ2 ρ3 ρ4

ADF

Statistic

Philips- Peron

Statistic

z(rho) z(t)

ECX Options Market

.00075 .00091 0.069 119.95 0.554 0.031 0.024 0.029

-15.52* -398.9# -16.1†

ECX Futures Market

Future

Dec-09 .00087 .00018 0.079 382.39 0.66 0.015 .034 .0098 -27.50* -976.2# -28.2†

CCX Spot Market

Vintage

2003 .00174 .0021 0.065 38.57 0.471 .077 .022 .086 -30.62* -1289# -31.4†

*Critical value at 5% significance level is -3.5

# Critical value at 5% significance level is -4.245

† Critical value at 5% significance level is -3.49

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This is the evidence of volatility clustering and suggests that volatility is predictable (Yu

2002). To test for the presence of unit roots, two tests, namely the Augmented Dickey-

Fuller (ADF) test and Philip-Peron (PP) test were performed. Corresponding statistics

were calculated and the results for ADF and PP are also presented in the last two columns

of Table 4.1. Both the tests confirm that the volatility series for the ECX Options and

Futures markets and the CCX spot market are stationary. The Results of DF-GLS unit-

root tests alongwith lags (selected through Schwert Information Criteria) are provided in

Table 4.2 and the results confirm the results of ADF and PP tests that the price series are

stationary. From graphical analysis these series were appearing to have structural breaks,

for which Zivot-Andrews test is carried out. The results given in Table 4.2 indicate that

any of these time series are not affected by structural breaks.

Table 4.2. Results of DF-GLS and Zivot-Andrews unit-root tests for carbon prices in ECX and CCX

Market of Carbon asset

lags DF-GLS Zivot-Andrews†

ECX Options

Market

2 -32.64* -2.5

ECX Futures

Market

1 -11.27* -3.3

CCX Spot

Market

1 -24.03* -3.25

*Critical value at 5% significance level is -3.19

†Critical value at 5% significance level is -5.08

4.7.3 Volatility analysis

First of all, a period has to be chosen for estimating parameters and a period for

predicting volatility. As the sample is rolled over, the models are re-estimated and ahead

daily forecasts are made. For all the three markets, 70% of the sample is used for

modeling the series and rest 30% is used for forecasting. The main results for the ECX

options market are presented in Table 4.3; for ECX futures market in Table 4.4; and for

CCX, Spot market in Table 4.5. The value and ranking of all eight competing models

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under the RMSE, and Theil-U are reported. The same models are evaluated under

asymmetric loss functions, where two LINEX loss functions are used (a = 20, and -20).

Table 4.3. Results for performance of econometric models for ECX Options Market

RMSE Theil-U LINEX (a=20) LINEX (a=-20)

Value Rank Value Rank Value Rank Value Rank

Random Walk 0.0148 2 1.00 2 0.045 2 0.0426 2

Historical Averages 0.1136 6 59.00 6 1.3659 6 6.623 6

Moving Averages 0.0422 4 8.14 4 0.2011 4 0.9164 4

OLS 0.0705 5 22.77 5 0.6477 5 1.7388 5

ARCH(1) 0.5717 8 1494 8 10.432 7 94.75 8

GARCH (1) 0.0145 1 0.9712 1 0.0409 1 0.042 1

Asymmetric

GARCH (1,1) 0.2352 7 234.6 7 27.67 8 19.67 7

NLGARCH (1,1) 0.016 3 1.1805 3 0.0647 3 0.046 3

For ECX options market, the RMSE, Theil-U and LINEX statistics, as given in Table 4.3,

indicate that the simple GARCH (1, 1) model provides the most accurate forecasts while

the random walk ranks second. ARCH model ranks the last and hence is not a very good

method to forecast volatility of ECX options market. These findings pertaining to the

ECX options market are consistent with the findings of ECX, Spot market (Benz and

Trück 2009) where price volatility is also described most accurately by simple GARCH

models.

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Table 4.4. Results for performance of econometric models for ECX Futures Market

RMSE Theil-U LINEX (a=20) LINEX (a=-20)

Value Rank Value Rank Value Rank Value Rank

Random Walk 0.0019 3 1 3 0.0008 3 0.0743 4

Historical Averages 0.0017 1 0.7912 1 0.0006 1 0.0566 1

Moving Averages 0.0018 2 0.8237 2 0.0007 2 0.0589 2

OLS 0.0071 5 13.4467 5 0.0095 5 1.0569 5

ARCH(1) 0.0297 8 235.6167 8 0.1028 8 0.2216 8

GARCH (1) 0.0217 6 126.2557 6 0.0621 6 8.6513 6

Asymmetric

GARCH (1,1) 0.0020 4 1.03383 4 0.0009 4 0.0738 3

NLGARCH(1,1) 0.0239 7 153.0988 7 0.0828 7 9.0397 7

Table 4.4 shows that for ECX futures market, all the measures of evaluation indicate that

the historical averages model provides the most accurate forecasts while the moving

averages ranks second for all the futures. Here also ARCH is not a very good method to

forecast volatility. This result of ECX futures market, contrasts not only with spot and

options markets of ECX, which are dominated by GARCH (1, 1) model, but also with

other futures markets like petroleum futures (Sadorsky 2006) and crude oil futures

(Moshiri and Foroutan 2006), for which volatility is described best by TGARCH model

and Non-linear GARCH models, respectively.

For the compliance market of ECX, in general, simple econometric models like the

historical averages and simple GARCH perform better than complex models for

forecasting purposes. This behavior of ECX is well contrasted with volatility of other

financial markets and energy markets for both spot trading and options and futures

stocks.

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Table 4.5. Results for performance of econometric models for CCX, Spot Market

RMSE Theil-U LINEX (a=20) LINEX (a=-20)

Value Rank Value Rank Value Rank Value Rank

Random Walk 0.0099 7 1 7 0.0198 7 0.0192 7

Historical

Averages 0.0090 5 0.6947 5 0.0164 5 0.0104 5

Moving Averages 0.0083 4 0.6866 4 0.0162 4 0.0103 4

OLS 0.0080 3 0.6698 3 0.0156 3 0.0100 3

ARCH(1) 0.0110 8 1.3314 8 0.0229 8 0.0286 8

GARCH (1,1) 0.0095 6 0.7944 6 0.0188 6 0.0159 6

Asymmetric

GARCH (1,1) 0.0077 2 0.6339 2 0.014 2 0.0099 2

NLGARCH (1,1) 0.0076 1 0.0037 1 0.0016 1 0.0050 1

From Table 4.5, it is evident that the results for CCX, spot market are quite contrasting as

compared to the ECX markets. A prominent feature of Chicago Climate exchange is the

dominance of non-linear model NLGARCH (1, 1) for forecasting. Here also the ARCH is

not a very good method to forecast volatility of CCX, thereby confirming the result of

worst performance of ARCH (1) in ECX also. Non-linear GARCH models perform quite

well overall for forecasting purposes in the case of Chicago Climate Exchange. This

characteristic of the spot market of CCX also contrasts with ECX, Spot market (Benz and

Trück 2009) and ECX, options market, which also are forecasted the best by GARCH

type of models; and also with ECX, futures market, which is forecasted well by a simple

econometric model of historical averages. However, the behavior of CCX, spot market is

similar to other financial markets like, for example, New Zealand (Yu 2002), Asian stock

markets (Michelfelder 2005), European stock markets (Balaban, Bayar and Faff 2006)

and German DAX index (Kaufman and Scheicher 2006); and energy markets like, for

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example, oil (Kang, Kang and Yoon 2008) and petroleum futures (Sardosky 2006), for

which the volatility is described best by the non-linear GARCH models.

Volatility analysis therefore shows that the volatility in voluntary market of CCX follows

the same pattern as the volatility in other financial markets and energy markets; whereas,

the patterns of volatility in the compliance market of ECX is different from such markets.

To understand the meaning of best performing models, it would be appropriate at this

stage to have a look at the coefficients of such models. Using STATA software, the

mathematical formulations for volatility, as obtained for the best performing GARCH

type of models in this chapter are obtained as follows.

ECX Options market:

∑∑ = −

=

−− ++=Ω≡p

j jt

q

i

itttt uuE1

2

1

2

1

22 752.0389.00067.0)( σσ (4.17)

In the expression on right hand side of equation (4.17), the second term refers to ARCH

coefficient and the third term corresponds to the GARCH effect. It is clear that GARCH

coefficient 2

jt−σ dominates the model, which means that volatility or uncertainty in the

past determines how volatile or uncertain the markets shall be there in future also.

CCX Futures Market:

2

1

2

11

2

11

22 972.0)(058.400002.00012.0)( −−−− +++=Ω≡ tttttt HuuE σσσ (4.18)

Equation (4.18) is clearly dominated by the non-linear term )( 2

11 −tH σ , which is taken as a

second order quadratic function (Sentana 1995). This means that simple GARCH effect is

totally negligible and complex non-linear terms describe the behavior of voluntary

market of CCX, which makes it quite similar to other financial markets and energy

markets; and different from the compliance market of ECX.

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4.8 Summary and conclusions

Growing concern over climate change leads to fixing of emission reduction targets in

different countries and regions. To fulfill this requirement, one of the options before the

GHG emitters is to go for carbon trading. As a result, growth in carbon market is

expected to soar (World Bank 2010). As carbon trade grows in importance, so does the

need to model and forecast the price movements in carbon markets. Volatility measures

the average absolute daily change, and is a common approach to indicate the variability

and unpredictability of the price of a tradable commodity. For carbon markets, in

particular, a full understanding of volatility of carbon prices is very critical. Forecasts of

carbon market volatility are important inputs into macroeconomic models and financial

risk assessment calculations like value at risk. Recently, a large volume of literature has

emerged on modeling and forecasting volatility in financial markets and energy markets

like oil and natural gas. In contrast, hardly any work has been done for carbon markets in

this direction. In this chapter, various econometric models are examined for forecasting

market volatility of three major carbon markets; the ECX options market, ECX futures

market and CCX spot market. Major findings of this chapter are explained in this section.

First, time-series data for volatility in all these carbon markets are stationary and there are

no structural breaks in the series despite the policy level transitions in the international

climate change scenario. Due to the stationarity property, volatility can be forecasted for

all carbon markets. An important consequence of this result is that top- level strategic

changes are not affecting the short-run fluctuations and hence market investors need not

be apprehensive about sudden shocks arising out of policy changes in the carbon markets.

Second, for forecasting purposes, GARCH (1, 1) model performs the best for ECX

options market, a finding that is similar to the ECX spot market, which is also forecasted

best by GARCH (1, 1) model (Benz and Trück 2009). This shows the similarity in

volatility behavior of ECX options market and the ECX spot market. On the other hand,

Historical Averages model performs the best for ECX futures market, thereby indicating

that the volatility dynamics of futures market in ECX are different from both spot and

options markets. A possible reason for this difference in volatility of ECX futures market

could be that carbon assets are traded in some future time, for which price is specified at

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present time (Bodie 2010), which implies different levels of uncertainty and hence

different volatility from ECX spot and options markets. However, one common factor is

that volatility in all the compliance markets of ECX (spot, options and futures) are

described by simple econometric models like GARCH (1, 1) and Historical Averages,

which is quite different from volatility behavior of all other financial markets and energy

markets (spot, options and futures).

Third, non-linear GARCH models perform better than others for the CCX spot market,

thereby indicating different behavior of this voluntary carbon market from the

compliance-bound ECX carbon market. This result is however similar to other financial

markets and energy markets like oil and gas, the volatility of which is also best described

by non-linear GARCH models; thereby indicating the similarity of voluntary carbon

market with conventional markets. High dominance of non-linear component in the

model completely rules out any closeness with simple GARCH models and hence with

the compliance market of ECX.

To sum up, this chapter shows that different carbon markets witness different volatility

patterns and hence separate econometric models are required for forecasting volatility for

each of these markets. The investors in voluntary carbon markets may follow the same

analysis as that of financial markets for predicting uncertainties and calculation of value-

at-risk. However, for the compliance carbon markets, different models have to be used

for forecasting purposes. The difference in compliance markets could possibly arise from

comparison with the marginal abatement costs and transaction costs in compliance

markets.

There are various limitations, however, in this study. First, being one of the pioneering

studies on forecasting carbon markets, it is limited to examination of volatility in price

only. Therefore only univariate models are considered here. Examination of multivariate

models that include trading volume may improve the forecast accuracy. Environmental

variables like weather patterns can further improve the accuracy. Other financial

variables like the number and type of listed companies on the climate exchanges and

policy issues like mandatory fixing of emission reduction targets by the federal or

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provincial governments in the EU and US may be some other useful variables to be

considered in this effort. Second, different markets became functional at different points

of time and hence slightly different time horizons have been used to forecast volatility.

Accuracy of forecasting might be improved after further passage of time, as more data

become available. Third, the effect of size and liquidity in the carbon market on the

quality of volatility forecasts is also an interesting and yet open question. Fourth, more

trading options have been introduced recently in both ECX and CCX, and their

comparison could bring better results. Finally, no structural breaks were observed in the

volatility of carbon markets, which shows that policy level changes so far did not have

very significant effects on the volatility dynamics of these markets. However, with

significant policy level changes at UNFCCC meets recently, some structural breaks may

arise in the data in future, which will need to be taken into account for further forecasting.

An array of additional financial instruments-options, derivatives, swaps, and so on are

becoming available in different carbon markets around the world to help firms hedge

volatility risk. Further investigation into the use of these models is suggested for all the

new carbon assets when more empirical data from other emerging carbon markets

become available.

Nonetheless, the findings of this chapter may be of immense use at the firm and policy

levels. At firm level, volatility behavior of emission allowances might enable companies

to compare the costs of emissions in their production process with carbon market

uncertainties. It could be useful in deciding not only about spot market investments, but

also about banking and borrowing of the carbon credits for future use. At the policy level,

the study may be helpful in choosing between carbon tax and the market based

instruments. Which of these two key market-based policy instruments, tax or trading,

should have the primary role in practice is much less clear cut. Both are mixed

government-market solutions: with taxes the government sets the carbon price and the

market sets the quantity of emissions; with trading the government sets the quantities of

emissions and the market sets the prices. Neither is, a priori, preferable on such

ideological lines (PWC 2009). Drawing comparisons between the forecasts of various

carbon markets from this chapter with expected returns from a carbon tax, the policy

makers can have a choice to go for either or a mix of the two. Knowledge of volatility

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behavior in different markets also presents policy makers an ability to choose from

different mechanisms to reduce uncertainties: To allow banking of allowances for future

use for motivating firms to further reduce their emissions now by allowing them to

establish a reserve for the future; or to allow firms to borrow allowances from future

periods; or to set price floor and/or ceiling to reduce the risks to investments in emission

reductions. In general, the results of this study are also going to be useful for anyone from

individual investors to policy makers, whosoever needs to forecast the carbon market

volatility.

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5 An Agent-Based Model of Carbon Markets

Abstract

Carbon markets comprise of various types of agents such as greenhouse gas emitters,

agriculturists, foresters and individual market investors. Genetically programmed agent

based models, which are the bottom-up simulations of actions, incorporate interactions of

such heterogeneous entities. These models possess considerably higher forecasting

capabilities than the traditional econometric models. Artificial carbon markets obtained

from such agent based models for the spot markets of European Climate Exchange

(ECX) and Chicago Climate Exchange (CCX) have stylized facts – lack of

autocorrelations, volatility clustering, heavy tails, conditional heavy tails, and non-

Gaussianity; which are similar to the actual carbon markets. Experiments are performed

on these artificially simulated carbon markets by changing wealth distribution of agents

from Equal to Pareto, and finally to Maxwell Boltzmann; by varying the distribution of

proportion of carbon assets from Equal to Gaussian; and lastly by changing the number of

agents in the carbon market from 5000 to 100000. Forecast accuracy is further improved

considerably, when the values of these agent parameters are closer to real market

situations. This virtue of experimentation is not available in the world of traditional

econometric models. Hence agent based models could play a key role in mimicking the

real world carbon markets and could provide an alternative to the analytical models.

Key Terms—Carbon market; agent based model; artificial market; genetic programming;

experimentation.

5.1 Introduction

Carbon markets have been recognized as one of most promising ways to stop the increase

of greenhouse gas (GHG) emissions efficiently and effectively (Brohe et.al. 2009). These

markets involve human activities and behavior, as they consist of various heterogeneous

agents such as greenhouse gas emitting companies, transporters, agriculturists, foresters,

individual arbitrageurs, hedgers and market investors. Following Farmer (1998), agents

in carbon market can be divided broadly into two categories: fundamental traders and

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technical traders. Fundamental traders take decisions on trading of a carbon asset if the

price of that asset departs from a value that they perceive as the fundamental one

(Martinez-Jaramillo and Tsang 2009). The price dynamics for such traders are driven up

and down by various factors like their marginal abatement costs (MAC); the ambition of

firms to increase their production capacity; to fulfill emission reduction targets

requirements fixed by the regulator in compliance markets; and to achieve the goal of

corporate social responsibility in voluntary markets. On the other hand, technical traders

make their investment decision rules purely on the basis of the market price of carbon

(Brock et.al. 1992). Technical analysis is an important tool for investment decision-

making and is being used extensively in other financial markets also (for example,

Dempster et.al., 2000, Raberto et. al., 2008, Alfi et.al., 2009, and Martinez-Jaramillo and

Tsang, 2009). Specifically for carbon markets, the World Bank report on state and trends

of carbon market (Kossoy and Ambrosi 2010) also argues that the trading in world’s

carbon markets so far is predominantly technical in nature. Therefore, for the purpose of

this chapter, it is presumed that agents in carbon market are technical traders, who make

investment in carbon markets purely on the basis of price movements in the market.

Due to heterogeneity among agents that comes from several sources: age, amount of cash

and carbon assets, total wealth, information, time horizon, and desired rate of return;

carbon markets have time-series for price and volume fluctuations, which provide some

of the big puzzles to be solved by the agents (Winker and Gilli 2001). Standard

econometric models like those used in financial markets (for example, Bollerslev, 1986;

Akgiray, 1989; Pagan and Schwert, 1990; Brailsford and Faff, 1996; Yu, 2002; Brooks

and Persand, 2002, 2003) and also in carbon markets (for example, Seifert et.al. 2008;

Homberg and Wagner 2007 and Chapter 3 and 4 of this thesis) for solving these puzzles

are based on fully rational behavior of homogenous agents. However, despite

overwhelming empirical support for the standard models, they cannot adequately

describe all typical features of market time series. Empirical features as volatility

persistence, excess kurtosis, equity premium, large Sharpe ratios, and predictable

deviations from fundamentals still do not have generally accepted explanations (LeBaron,

Arthur, and Palmer 1998), which might be due to heterogeneity of agents, because of

which it is difficult to expect completely rational behavior (Chen and Yeh 2002). To

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allow for limited rational behavior of the agents, it would be appropriate to explore the

world of agent based models (like for example, Martinez-Jaramillo and Tsang 2009;

Tesfatsion, L. 2005; Tseng 2010), where interactions between agents are taken explicitly

into account that influence the outcomes of market price. An agent-based model is a

bottom-up simulation of the actions and interactions of multiple autonomous entities for

the purpose of analyzing the emergent effects on a system as a whole (Witkam 2010).

Agent based models have already been applied to financial markets, for example, by

using the methodologies of non-equilibrium statistical mechanics to elucidate the

mechanisms underlying the complexity by Mantegna and Stanley (2000); using critical

phenomenon by Stanley et.al. (2002); and using self-organized criticality by Scheinkman

and Woodford (1994). Most influential work in this direction, however, is carried out by

Santa Fe Artificial Stock Market (Arthur et.al., 1997) and Artificial Economic Life

(Palmer et.al., 1994). A good discussion of computational finance is also given in Tsang

and Martinez-Jaramillo (2004); of agent based financial markets in LeBaron (2001); and

of agent based computational economics in Tesfatsion (2001). Complexity of the agent

behavior is the main motivation for using alternative methodologies to gain a better

understanding of some of the unsolved problems in carbon market dynamics. Agent-

based models have shown to be able to simulate complex systems better than traditional

mathematical finance. The model consists of a population of agents, representing

investors with their own assets and trading strategy and a price discovery mechanism that

represents a market (LeBaron, Arthur, and Palmer 1998).

Prices in carbon market are established by investors with different decision making

methods and different investment goals such as risk preference and time horizon.

Complex dynamics of these heterogeneous investors and the resulting price formation

process require a simulation model of multiple heterogeneous agents and a virtual market

or an agent based market. Complex behavior as seen in actual markets can emerge from

simulations of agents with relatively simple decision rules (Witkam 2010) in such

markets. These artificial markets are inspired by the notion that markets can be seen as an

adaptive, complex system with rich dynamics and emergent properties. Such properties

should arise endogenously rather than being imposed exogenously. By using this

approach the intention is to overcome the limitations of traditional theory in which many

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unrealistic assumptions have to be made to allow tractability (Tseng et.al 2010). Research

in this field is increasingly gaining acceptance in the fields of ecology, environment and

economics (Mzuta and Yamagata 2005). Different studies in this field differ from each

other in the set of assumptions made, and the methodology and tools used; but the

evolved markets share the same common property: the macro behavior of such market,

depicted by the price movements, should emerge endogenously as a result of the micro-

interactions of the heterogeneous market participants. This chapter, therefore, is focused

on study of an agent based model for traders who invest in carbon assets depending on

price movements in the carbon market. The main objective is to model the artificial

carbon market by use of a simple market mechanism and computationally sophisticated

genetically programd agents. The resemblance of this artificial market to the real market

is checked through verification of stylized facts of both. In addition, experiments are

conducted on such an artificial market to understand the carbon market behavior in

response to changes in circumstances. Such behavioral dynamics are studied by varying

different parameters in the artificial market and observing the change in price

movements.

The rest of this chapter is organized as follows. Section 5.2 describes the theoretical

framework for the model of agents and the model of price determination apart from

trading rules of agents. Section 5.3 provides the details of Adaptive Modeler, the software

platform for carrying out agent based modeling. Section 5.4 explains the parameters of

the agent based model. In Section 5.5 the statistical properties or the stylized facts of

carbon markets are explained. In Section 5.6, artificial carbon markets are simulated and

their stylized facts are compared with the real world markets. In section 5.7, experiments

to be performed on artificial carbon market are explained. Section 5.8 describes the

results of these experiments. Section 5.9 presents summary and conclusions.

5.2 Theoretical Framework

In this chapter, the basic framework of Santa Fe Institute (SFI) and that of the standard

asset pricing model of Grossman and Stiglitz (1980) is followed for developing an

artificial carbon market, which is a simulated market created on a software platform using

an agent-based model. This artificial market allows a user to experiment with different

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scenarios using various combinations of traders, behavior and characteristics. Carbon

markets are populated by heterogeneous traders that interact with each other by means of

buying and selling of the carbon assets, which are emission allowances that are allotted to

them by means of allotment or auction by the government in the compliance market; or

purchased from voluntary market as a matter of corporate social responsibility (Benz and

Trück 2009). The goal of each of the agents is to maximize the expected utility based on

the forecast of the future price of carbon assets. In this section, the abstract model and its

main characteristics are explained.

5.2.1 Model of agents

The agent part includes the objectives of carbon market agents and their utility functions.

For simplicity, it is assumed that all agents in carbon market have same utility function,

which is a constant absolute risk version (CARA) utility function:

)exp()( ,, titi WWU λ−−= (5.1)

where Wi,t is the wealth of agent i at time-period t, and λ is the degree of relative risk

aversion. Agents can accumulate wealth or step up their industrial production process by

purchasing carbon instruments or bank carbon assets for future use by making

investments in the carbon market. By following the approach of SFI, it is assumed that

there are two assets available to an agent in the carbon market. One is the riskless

interest-bearing asset called money, denoted by Mi,t, and the other is a risky asset, the

carbon instrument, denoted by ci,t. At each point in time, each agent has these two options

to keep his wealth, which can be written mathematically as

tittiti cPMW ,,, += (5.2)

Given this combination of money and carbon assets (Mi,t , ci,t), an agent’s total wealth

Wi,t+1 , during next period of time t+1 is therefore,

)()1( 11,,1, +++ +++= tttititi dPcMrW (5.3)

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Pt is the price of carbon asset at time period t; r is the risk-free interest rate; and dt is per

asset stochastic dividend obtained by the market traders in terms of benefits arising out of

increased production levels, reduction in abatement costs or using these assets at some

future time. Following (LaBaron 2002), it is assumed that dt follows the following mean-

reverting autoregressive Ornstein-Uhlenbeck process:

ttt dddd µρ +−+=−

)( 1 (5.4)

where −

d is the mean dividend, ρ is the speed of mean reversion, and tµ refers to

stochastic shocks which are normally distributed with mean zero and variance 2

µσ . The

price of carbon asset, Pt, is determined endogenously in the market. Given that the wealth

is dynamic, the goal of each agent is to maximize the expected utility function over one

period,

))exp(())(( ,1,1,, ttititi IWEWUE ++ −−= λ , subject to equation (5.3), where (.),tiE is agent i’s

conditional expectations of 1+tW given his information set tiI , . The choice variable of this

optimization problem is tic , , the number of carbon assets at time t. Under the assumption

of normally distributed market returns, the amount of carbon assets tic ,ˆ that agents desire

to hold is determined as

2

,

11,

,

)1(][ˆ

dPt

tttti

ti

rPdPEc

+

++ +−+=

λσ, (5.5)

where ][ 11, ++ + ttti dPE is I’s expectation in t about next period’s realization of the carbon

asset price and dividend, and 2

, dPt +σ the empirically observed variance of the asset’s

combined price plus dividend time series (LaBaron 2002).

5.2.2 Model of price determination

Demand for carbon assets by an agent is the difference of his actual and desired asset

holdings. Once agents have determined their effective demands, they submit them to a

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market specialist, who tries to balance the effective demands by setting a market clearing

price. Given tic ,ˆ , the market mechanism is described as follows. Let tib , be the bids or

number of carbon assets that agent i would like to buy at period t, and let tis , be the offers

or number of assets that agent i would like to sell at period t. It is clear that

1,,,ˆ

−−= tititi ccb , if 1,,ˆ

−≥ titi cc

0, otherwise (5.6)

and

tititi ccs ,1,,ˆ−= − , if 1,,

ˆ−≤ titi cc

0, otherwise (5.7)

It is apparent from equations 5.6 and 5.7 that an agent can only buy or sell but not both at

the same time. Furthermore, let

∑=

=N

i

tit bB1

, (5.8)

and

∑=

=N

i

tit sS1

, (5.9)

be the totals of bid and offers, respectively for carbon asset at time t, where N is the

number of agents. Following Palmer et. al. (1994), there is a very simple price adjustment

scheme, based solely on excess demand Bt-St:

))(1(1 tttt SBPP −+=+ β (5.10)

Where β is a function of the difference between Bt and St. β can be interpreted as the

speed of adjustment of prices that follows the hyperbolic tangent function.

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5.2.3 Trading rules and expectation formations

Agents make use of trading rules to make predictions on the mean and variance of returns

in carbon market. A rule tells each agent how to forecast future returns, and what the

conditional variance of this forecast is. While traders are homogeneous with respect to

their utility functions and degrees of risk aversion, they differ when deriving their

expectations ][ 11, ++ + ttti dPE . Price forecast is generated by using individual trading rules

of the type

If (condition fulfilled), then (derive forecast)

First, a forecast is produced using equation (5.5), and then will be converted into an

action, i.e., an agent’s bid or offer for carbon asset. Each of the j trading rules that every

agent possesses consists of a condition part, a forecast part (predictor), a fitness

parameter and forecast accuracy i.e.

rulei,j = (condition part); (predictor); fitness parameter, forecast accuracy

The condition parts, as defined by equations (5.6) and (5.8) are checked against a

Boolean market descriptor, which holds current and past information on price. From the

set of j individual trading rules, normally several rules match the market descriptor.

Agents chose one of them for forecast production, selecting the best rule, based on

forecast accuracy (LeBaron 1999). Finally, the agent determines the forecast, assuming it

to be linear in current price and dividend.

jtjjttti bdPadPE ++=+ ++ )()( 11, (5.11)

The subscript j refers to the rule chosen by agent i. This restricted forecasting rule along

with the demand for carbon assets gives a demand function which is linear in Pt. Setting

the total number of carbon assets to a fixed value allows for solution of the demand

equation (5.5) for a temporary equilibrium price. This assumption is justified as total

number of assets is fixed by the regulator depending on the overall cap on emissions.

After the price is set, agents update their portfolios, and trading volume is recorded.

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5.2.4 Learning

For the purpose of forecasting prices in artificial carbon markets, an individual is viewed

or modeled as a collection of decision rules, which dictate the actions to be taken in given

situations and a set of preferences used to evaluate the outcomes arising from particular

situation-action combinations. These decision rules are continuously subject to review

and revision; new decision rules are tried and tested against experience, and rules that

produce desirable outcomes supplant those that do not (Lucas 1986). For modeling of this

learning process, the technique of genetic programming is used, in which agents are

represented by computer programs. This technique has been used in the past to perform

technical analysis by various research groups like Garcia-Almanza and Tsang (2006),

Markose et.al (2003), Dempster et.al. (2001), Yeh and Chen (2000), Edmonds (1999),

Edmonds and Moss (1997), Neely et.al. (1997); and has been described as a suitable way

to model economic learning in Brenner (2005). Genetic programming (GP) is an

evolutionary computing technique inspired by biological evolution to optimize a

population of agents or the computer programs to perform a certain task. Computer

programs are created from a high level problem statement and are the lingua franca for

expressing solutions to a wide variety of problems. The first generation of agents or

programs is created randomly. GP then breeds a population of computer programs

genetically using the principles of Darwinian Natural Selection and biologically inspired

operations like reproduction, mutation and cross-over (Koza 1992). These programs are

evaluated by a fitness function that measures how well the program performs the task or

solves the problem. Fitter programs get selected over less fit programs to participate in

reproduction or recombination operations to create a new generation of programs or

agents. In a recombination operation such as crossover, randomly chosen parts (sets of

genes) of two programs are exchanged to create two new programs. A mutation operator

can also be applied to randomly change a small part of a program (Witkam 2010, 34-36).

The process of creating new generations is repeated until one or more agents or programs

in the population have achieved a satisfactory fitness level. A typical flowchart of

Genetic Programming is given in Koza (1992) and is reproduced in Appendix-1.

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5.3 Adaptive Modeler- The Software Platform

To develop an artificial carbon market in this chapter, a GP-based software system called

Adaptive Modeler is used, which constitutes basic platform for the design of investment

strategy of agents. Important features of this software are described in this section.

Adaptive Modeler consists of an agent-based model that receives price quotes from the

real world carbon markets and produces price forecasts. This framework is depicted in

Fig. 5.1. The model consists primarily of a population of agents and a virtual carbon

market (VCM), where agents can trade the security. An agent is an autonomous entity

representing a trader or investor with its own assets, which could be cash and/or carbon

instruments and its own trading strategy. After initialization, a new model starts evolving

by executing its regular cycle for every received quote price on daily basis from the

carbon market.

Fig. 5.1. Cycle of an agent based model in Adaptive Modeler

After a new price quote bar from carbon market is received every day, agents can place a

new order or remain inactive according to their trading strategy, which is buying or

selling according to equations (5.8) or (5.9). After all agents have evaluated their trading

Agent-based

Model Cycle

Receive new price quote daily from real-world carbon market

Breeding Agents evaluate trading rules and place orders

Virtual market clearing and forecast

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strategy, the virtual carbon market determines the clearing price using equation (5.10),

executes all executable orders and releases the price forecast for the next day. Finally,

breeding of new agents and replacement can take place by evolutionary operations such

as crossover and mutation. Total amount of wealth in the model keeps varying because of

agent replacements due to evolutionary operations. Total number of carbon assets that

exist in the model also changes because of agent replacements. This process then repeats

itself for the next quote price received on next day (Witkam 2010).

5.4 Model Parameters

In Adaptive Modeler, a model initialization is done for a population of agents according

to specified parameters. The parameters of the model used in this chapter are described in

this section.

5.4.1 Population Size

Population size is the total number of agents in the model of carbon market. Bigger the

population, more are the trading rules competing and evolving in parallel. This increases

the chance of new trading rules with rise of new opportunities in the market. A bigger

population also increases the ability of a model to endure different market regimes as

more strategies could be stored in the trading rules of agents. A larger population size

also increases model stability and prevents models from extreme forecasts or from a state

of imbalance (Koza 1992). However, bigger populations require more computations and

make model evolution slower.

5.4.2 Wealth distribution

Wealth distribution is an important parameter of agents and has a great influence on the

artificial or virtual market price. If initial wealth is assigned to agents by making use of

random sampling methods, noise might be added to the price discovery mechanism

(Witkam 2010). To avoid such noise, equal initial wealth is generally assigned to all

agents. However, it is not expected to be close to reality as agents with different wealth

are trading in the actual carbon market.

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5.4.3 Position distribution

Position distribution is the proportion of carbon allowances to the total wealth of an agent

and another important parameter in an agent based model. It is fixed initially and then-

after it keeps varying during model evolution because of agent replacement. Furthermore,

initial position of an agent gets changed immediately after its creation as a consequence

of trading according to its trading rule. The position distribution may therefore diverge

from the chosen initial distribution during model evolution.

5.4.4 Basis of forecast

In Adaptive Modeler, one can specify whether the forecast should be based on i). Virtual

Market Price (VMP), which is the clearing price on the Virtual Market, based on the

orders that are placed by all the agents; or on ii). Best Agents Price (BAP), which is the

price, calculated using only the orders of a group of best performing agents. The size of

the Best Agents group can be specified as a percentage of the total population size, which

is fixed at 2.5% for experiments in this chapter. The rationale for using the virtual market

price as an indicator for future prices that due to the volume weighted clearing price

computation mechanism, wealthier or more successful agents, who generally place bigger

orders, will have a bigger influence on the market price than less wealthy or less

successful agents. This way the forecast calculation mechanism has a preference for

successful trading strategies but still includes a high number of diverse trading strategies.

Hence VMP is needed to make the forecasting mechanism more robust to changes in

market behavior since previously successful trading strategies are not guaranteed to

remain successful in the future (Witkam 2010). However, it is interesting to compare the

forecasting abilities of the entire Virtual Market with those of a much smaller group of

only the best performing agents.

5.4.5 Trading rules

Each agent receives a technical trading rule, called genome that is randomly created

according to the genome settings in genetic programming. After all initialization

processes, the agent population evaluates its trading rules, and then trade, and finally

breed, according to the agent-based model cycle. Trading rules in Adaptive Modeler use

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76

carbon market price data as input and, according to their internal logic, return an advice

consisting of a desired position of carbon assets, as a percentage of wealth.

5.4.6 Breeding

Breeding is the process of creating new agents to replace poor performing agents and is

implemented with Genetic Programming (GP) technology. Breeding occurs by selecting

pairs of well performing agents (parents) and producing new genomes by recombination

of the parent genomes through a crossover operation. In a crossover operation, the parent

genomes are copied and then a randomly chosen part of the copied genome of one parent

gets exchanged for a randomly chosen part of the copied genome of the other parent

(Koza 1992). The resulting two new genomes are used to create two new agents. In

Adaptive Modeler a steady-state approach for generations is used in which only a small

part of the population is replaced at a time, typically every day, instead of the entire

population at once. This allows for a gradually changing population which is necessary to

maintain a certain degree of model stability. Parents are selected according to the

parameters minimum breeding age, which is fixed at 80 days in this study. First an initial

selection is made. This is a temporary sub population in which breeding and replacement

takes place. The initial selection consists of a given percentage of all agents of minimum

breeding age and older. Thenafter p best performing agents are selected as parents,

judged by the breeding fitness return of the initial selection, where p is the value of parent

selection parameter (Witkam 2010). In this chapter, p is kept fixed at 2.5%.

5.5 Statistical Properties of Carbon Markets

In this chapter, price time-series data from two carbon markets is taken: European

Climate Exchange (ECX) spot market, which is a compliance market and Chicago

Climate Exchange (CCX) spot market, which is a voluntary carbon market. For the sake

of brevity, ECX and CCX shall be used to indicate these two spot carbon markets,

respectively, throughout the chapter. Following (Yu 2002), statistical analysis is

performed on these time-series using log returns, which are defined in the following way:

1

1

log −

−=≡ tt

t

tt pp

P

Pr (5.12)

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77

where tt Pp log≡ . The advantage of using this type of return is that it is easier to derive

the time-series properties of an additive process than multiplicative processes. Fig. 5.2

illustrates the daily closing prices and Fig. 5.3 depicts log returns for ECX. Similarly Fig.

5.4 and Fig. 5.5 indicate the same statistics for CCX.

Time-series of log returns in financial markets exhibit some interesting statistical features

known as stylized facts, which are a very important benchmark for the research in

artificial markets (Martinez-Jaramillo and Tsang 2010). In financial markets, they are

seen as the first verification criteria for building a simulated market. Many different types

of stylized facts are found in the already existing market literature. However, for the two

markets, the approach of Winker and Gilli (2001) is followed and five stylized facts are

considered, which the most common ones are; and different tests are performed to verify

that our endogenously generated price in the model mimics these statistical properties.

10

20

30

40

50

Price

0 200 400 600 800 1000Time (Days)

-.1

0.1

.2Log Return

0 200 400 600 800 1000Time (Days)

Fig. 5.2. Closing Prices ECX Fig 5.3. Log Returns ECX

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02

46

8Price (US$)

0 500 1000 1500 2000Time (Days)

-.4

-.2

0.2

.4Log Return

0 500 1000 1500 2000Time (Days)

Fig. 5.4. Closing Prices CCX Fig 5.5. Log Returns CCX

5.5.1 Lack of autocorrelations

Autocorrelation is the cross-correlation of a time-series with itself. It is the similarity

between observations as a function of the time separation between them and is a

mathematical tool for finding repeating patterns. Linear autocorrelations of log returns

are generally insignificant for financial time-series (Winker and Gilli 2001). Since the

data consists of daily time-series for the two carbon markets, so testing is carried out for

the same. The autocorrelation function is defined as

C (τ) = corr (rt, rt+ τ) (5.13)

where τ is the time lag.

From Fig. 5.5 and Fig. 5.6, it is observed that the autocorrelation of the log returns for

different time lags fluctuates around zero for ECX and CCX. So this property is satisfied

for both real world carbon markets.

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79

-0.40

-0.30

-0.20

-0.10

0.00

0.10

AC logreturns ECX

0 10 20 30 40Lag

-0.10

-0.05

0.00

0.05

0.10

AC logreturn CCX

0 20 40 60 80 100Lag

Fig 5.6. Autocorrelations log returns ECX Fig 5.7. Autocorrelations log returns CCX

5.5.2 Volatility clustering

Different measures of volatility display a positive autocorrelation over several days,

which indicate that high-volatility events tend to cluster in time (Martinez-Jaramillo and

Tsang 2010). The autocorrelations of absolute log returns allow investigating this

phenomenon. Empirical studies, for example by Manderbolt (1963) have shown that the

autocorrelation function of absolute returns remains mostly positive and decays over

several lags. This is interpreted as a sign of long range dependence. For both of real-

world carbon markets, this property also holds true, as is evident from Fig. 5.8 for ECX

and Fig. 5.9 for CCX.

5.5.3 Heavy tails

In probability theory, heavy-tailed distributions are probability distributions whose tails

are not exponentially bounded, that is, they have heavier tails than the exponential or the

normal distribution.In order to be able to determine the tail distribution, the log returns’

kurtosis is reported, which is the fourth central moment of a distribution and it measures

the degree of flatness of a distribution near its center (Lux 1998). Distribution of daily

and higher frequency returns in financial markets displays a heavy tail with positive

excess kurtosis. For a normal distribution, the kurtosis is three. If it is more than three, the

phenomenon is known as excess kurtosis and is an indication of fat tails (Wooldridge

2008).

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80

-0.20

0.00

0.20

0.40

AC absolute logreturns ECX

0 10 20 30 40Lag

-0.05

0.00

0.05

0.10

0.15

0.20

AC absolute logreturn CCX

0 20 40 60 80 100Lag

Fig 5.8. Autocorrelations absolute log returns ECX

Fig 5.9. Autocorrelations absolute log returns CCX

It could be observed from Table 5.1 that Kurtosis for the log returns of ECX and CCX

follow a fat tail distribution and hence satisfy this property.

Table 5.1. Statistics for log returns for price in ECX and CCX

Statistics Log-Return

ECX CCX

Kurtosis 221 328

J-B Test H 1 1

ARCH 0.235 0.141

GARCH 0.176 0.310

5.5.4 Conditional heavy tails

Even after correcting returns for volatility clustering (e.g. via GARCH-type models), the

residual time series still exhibit heavy tails. However, the tails are less heavy than in the

unconditional distribution of returns. This property is tested by checking the values of

ARCH and GARCH coefficients. If both the coefficients are less than one, the property

of conditional heavy tails is satisfied (Martinez-Jaramillo and Tsang 2010). From Table

5.1, it is clear that this property is satisfied by both the carbon markets.

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5.5.5 Non-Gaussianity

Market returns fail to be normally distributed, as financial series, particularly logarithmic

returns, are believed to be non-normal, partly due to the fat tails. Following Lux (1998),

this property is checked using Jarque-Bera test. For both ECX and CCX carbon markets,

the test values reject the null hypothesis that the sampled data is drawn from a normal

distribution. Hence the time series data in both the carbon markets satisfy non-gaussianity

property also.

Therefore the real market data from both the carbon markets of ECX and CCX satisfies

all the stylized facts of financial markets and hence simulation could be carried out for

these markets, which is done in subsequent sections.

5.6 The Simulation

For simulating artificial carbon markets in Adaptive Modeler, it is assumed that both the

carbon markets of ECX and CCX operate as if each trading round is one day. The results

of simulation runs for agent based model on the data from European Climate Exchange

(ECX), and the Chicago Climate Exchange (CCX), are presented in this section. The

statistics for the actual and artificially simulated carbon markets are shown in Table 5.2.

Table 5.2. Summary Statistics for the Log Returns of prices of actual and

artificially simulated carbon markets

Actual Carbon Markets Artificial Carbon Markets

ECX CCX ECXA CCXA

Mean -0.0031 -0.0023 -0.0027 -0.0018

Max 0.881 3.26 0.732 3.91

Min -1.27 -3.04 -1.85 -3.69

Skewness -5.40 0.54 -7.74 0.43

s.d. 0.62 0.19 0.57 0.21

Variance 0.0072 0.037 0.0086 0.050

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Tests are conducted for the statistical properties or the stylized facts on the time-series of

log returns for the two simulated markets using both Virtual Market Price (VMP) and the

Best Agents Price (BAP). It is verified whether the simulated prices in the model mimic

the statistical properties of real-world carbon markets or not. The findings are described

subsequently.

5.6.1 Lack of autocorrelations

Linear autocorrelations of log returns are found to be insignificant for both the simulated

markets for both virtual market price (Fig. 5.10 and Fig.5.12) and the best agents’ price

(Fig. 5.14 and Fig. 5.16). It can be easily observed that the autocorrelation of the log

returns for different time lags is around zero for both ECX and CCX under both the

options of VMP and BAP. Hence the simulated artificial carbon markets follow stylized

fact for lack of autocorrelations.

.

-0.30

-0.20

-0.10

0.00

0.10

AC logreturns ECX VMP

0 10 20 30 40Lag

-0.10

0.00

0.10

0.20

0.30

AC absolute logreturn ECX VMP

0 10 20 30 40Lag

Fig 5.10. Autocorrelations log returns ECX,

VMP

Fig 5.11. Autocorrelations absolute log returns

ECX, VMP

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-0.20

-0.10

0.00

0.10

AC logreturn CCX VMP

0 20 40 60 80 100Lag

-0.05

0.00

0.05

0.10

0.15

0.20

AC absolute logreturn CCX VMP

0 20 40 60 80 100Lag

Fig 5.12. Autocorrelations log returns CCX,

VMP

Fig 5.13. Autocorrelations absolute log returns

CCX, VMP

5.6.2 Volatility clustering

Figures 5.11 and 5.13 show that for both simulated carbon market under VMP, the

autocorrelation function of absolute returns remains positive and decays over several

lags. So the stylized fact of volatility clustering is also satisfied by both the simulated

carbon markets under VMP. However, this fact is not satisfied for BAP, as is evident

from Fig. 5.15 and 5.17 for the simulated markets of ECX and CCX, respectively

-0.05

0.00

0.05

0.10

AC logreturns ECX BAP

0 10 20 30 40Lag

-0.05

0.00

0.05

0.10

AC absolute logreturns ECX BAP

0 10 20 30 40Lag

Fig 5.14. Autocorrelations log returns

ECX, BAP

Fig 5.15. Autocorrelations absolute log

returns ECX, BAP

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-0.30

-0.20

-0.10

0.00

0.10

0.20

AC logreturn CCX BAP

0 20 40 60 80 100Lag

-0.10

0.00

0.10

0.20

0.30

AC absolute logreturn CCX BAP

0 20 40 60 80 100Lag

Fig 5.16. Autocorrelations log returns

CCX, BAP

Fig 5.17. Autocorrelations absolute log

returns CCX, BAP

5.6.3 Heavy tails

The distribution of daily and higher frequency returns is also checked for the simulated

markets for positive excess kurtosis. From Table 5.3, it is clear from the values of

kurtosis that log returns for both simulated markets follow a fat tail distribution under

both VMP and BAP criteria. Hence the price series of simulated markets satisfy this

statistical property also.

Table 5.3. Statistics for the log returns for the price series of the

simulated carbon markets of ECX and CCX

Virtual Market Price Best Agents Price

ECX CCX ECX CCX

Kurtosis 221 328 497 489

J-B Test,

H -value

1 1 1 1

ARCH 0.533 0.387 No results No results

GARCH 0.708 0.881 No results No results

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5.6.4 Conditional heavy tails

From Table 5.3, it is evident that both ARCH and GARCH coefficients are less than one

for VMP, thereby indicating that this stylized fact is satisfied by the artificially simulated

carbon markets under virtual market price criterion. However, under BAP criterion, no

values are returned for both the markets, again indicating failure of the model under best

agents’ price criterion.

5.6.5 Non-Gaussianity

This statistical property is checked using Jarque-Bera test on price-series of both

simulated markets. From Table 5.3, it is evident that for the price-series both the

simulated markets for ECX and CCX, the test values reject the null hypothesis that the

simulated data follows a normal distribution. Hence the time series data in both the

artificial carbon markets satisfy non-gaussianity property also under both VMP and BAP

criteria.

From this section, it is evident that the simulated carbon markets using an agent-based

model satisfy the statistical properties or the stylized facts of the financial markets under

virtual market price criterion and hence could be used for forecasting purposes. However,

all stylized facts are not satisfied for the best agents’ price. Even for the virtual market

price, it would be important to adjust parameters of the model, so as to achieve maximum

accuracy of forecast. Next section is devoted to carrying some experiments with the two

artificial markets to improve forecast capabilities of the agent-based model in carbon

markets.

5.7 Experimentation with artificial carbon markets

This section describes a series of experiments performed on the artificial carbon markets

of ECX and CCX using Adaptive Modeler software with an aim to understand carbon

market behavior. Three experiments are performed to see how forecasting performance

changes in the artificial markets, when model parameters are changed. Three sets of

parameters involved in the simulation are: wealth distribution; proportion of allowances;

and the number of agents. Other parameters are kept fixed for the sake of simplicity. For

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analytical econometric models, Brooks (1998), Yu (2002), Bollerslev (1986), Akgiray

(1989), Pagan and Schwert (1990), Benz and Trück (2009) and Chapter 4 of this thesis

indicate that in financial markets and carbon markets, most of the price series are

described most accurately by GARCH types of models. In this section, a comparison is

also made for forecasting performance of GARCH type of models with agent based

models. The rationale for using these parameters for experimentation is explained first.

5.7.1 Wealth distribution of agents (W)

In both the carbon markets of Europe and Chicago, there is an involvement of agents of

diverse backgrounds. In Europe, emission reduction targets are fixed by the regulator,

whereas in Chicago, the involvement of agents is purely on voluntary basis. Even though

the nature of EU and Chicago market is different in this respect, there is one common

factor: agents with different wealth levels are participating in both of them. Therefore it

appears reasonable to see how forecasting performance of the model changes when we

change the wealth distribution of the agents in the artificially simulated markets. For

experimentation in this chapter, initial wealth is assigned to the agents by the following

methods:

(a). Equal for all agents: All agents are assigned the same initial wealth. Though it is not

realistic to expect equal wealth for all agents in the real market, it could be a good

starting point for simulation exercise.

(b). Pareto distribution: Here, the agent wealth is randomly sampled from a Pareto

distribution, which is a well known power law distribution commonly used to describe

wealth or income distributions. In particular it describes an unequal distribution where a

large part of total wealth is owned by a small percentage of individuals, generally in the

80-20 ratio. Pareto distribution has been used considerably in the financial market

literature, for example by Reed (2010) to describe wealth of a population of agents; and

hence is used in experimentation for the purpose of this study also.

(c). Maxwell-Boltzmann distribution: Agent wealth can also be randomly sampled from a

Maxwell-Boltzmann distribution. This is an exponential distribution originating from the

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field of statistical mechanics for describing the distribution of energy of atoms in a gas. In

econo-physics, for example, by Mantegna and Stanley (2000), its general significance has

been recognized for describing the distribution of money among agents in an economy.

Although money may be considered conserved in a closed economy, wealth, when it

includes non-cash assets, is not necessarily conserved. Wealth may change due to

changes in asset prices or through the creation and destruction of assets. For example, in

carbon markets, agents may keep selling, buying or retiring carbon credits, depending

upon their emission reduction commitments, production enhancement motives or social

and environmental obligations. Maxwell-Boltzmann distribution is the most random

distribution among all of these distributions (Laurendeau 2003).

5.7.2 Proportion of carbon allowances vis-à-vis total wealth (P)

In EU countries, due to fixing of targets under Kyoto Protocol, CO2 allowance

distribution is done by the government to different emitters. The allowances are either

allotted or auctioned initially by the government regulator within the overall cap on

emissions. Subsequently, if any company wishes to emit more, it has to buy allowances

from the market. Similarly those companies that have reduced their targets below the

fixed levels can sell the surplus allowances. However in USA, there is no government

regulation for the emission targets. So it is completely up to the emitters to buy or sell

carbon allowances in the market (Point Carbon 2009). This makes the nature of EU and

Chicago markets different from each other. Therefore it is expected for the model to

perform in a different way for changing the proportion of carbon assets among different

agents. Therefore an experiment is performed to compare the forecasting accuracy of the

agent based model by varying initial proportion of carbon assets in these markets by two

distributions: (a). Equal: When all agents get the same initial allotment of carbon assets.

The position can be specified initially and is chosen to vary within [-100%, 100%]; and

(b). Gaussian: Where an agent’s position is randomly sampled from a Gaussian (Normal)

distribution with the specified mean and standard deviation. The mean is chosen to vary

within [-100%, 100%].

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5.7.3 Number of agents (N)

Carbon markets are expanding day by day. With more and more countries fixing

emission reduction targets and the growing environmental consciousness, it is expected

that more carbon markets will be established around the world. Already the markets have

become operational in China, Japan, Australia and various other countries (World Bank,

2009). As a result, it is expected that the number of agents will also go on increasing in

the times to come. Therefore it seems reasonable to carry out experiments to see the

forecasting performance of an agent based model with change in the number of agents N.

This experiment is performed with N equal to 5000, 25000, 50000 and 100000 and

change in forecasting accuracy is noticed.

Following Yu (2002), comparison of artificially simulated markets with real carbon

markets is made using the two evaluation measures of Root Mean Square Error (RMSE)

and Mean Absolute Error (MAE) to see the forecasting accuracy. These evaluation

measures are defined as

RMSE = ∑=

−I

i

ii ppI 1

2)ˆ(1

(5.13)

MAE = ∑=

−I

i

ii ppI 1

ˆ1

(5.14)

Where, ip is the forecasted price, ip is the carbon price from actual data on ith day and I

the number of days of trading.

5.8 Results and discussion of Experiments

The results of experiments show very striking findings in the use of agent based models

for forecasting in carbon markets. One common finding in these experiments is that both

the indicators perform consistently for the two markets and for different parameters, as

shall be clear from the subsequent discussion.

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5.8.1 Changing W

The results of experiments, by changing wealth of agents, performed on the simulated

markets of European Climate Exchange (ECX) and the Chicago Climate Exchange

(CCX) are given in Table 5.4. From these results, it is evident that forecasting accuracy

using both the performance indicators improve continuously as the initial distribution of

wealth is changed from Equal to Pareto and then to Maxwell-Boltzmann for both ECX

and CCX. The numbers in parenthesis indicate the rank in forecasting accuracy.

Table 5.4. Results of experiments on artificial carbon markets for different wealth

distribution of agents

ECX CCX

Initial wealth distribution

Equal Pareto Maxwell-Boltzmann

Equal Pareto Maxwell-Boltzmann

RMSE 0.092

(3)

0.057

(2)

0.013

(1)

0.086

(3)

0.065

(2)

0.032

(1)

MAE 0.075

(3)

0.026

(2)

0.003

(1)

0.067

(3)

0.035

(2)

0.015

(1)

Figures in parentheses indicate ranking of forecasting accuracy

The results obtained in Table 5.4 indicate that for forecasting both compliance and

voluntary carbon markets, maximum accuracy of forecast is obtained, when we allot

initial wealth among agents according to Maxwell-Boltzmann distribution. This result

seems quite intuitive, as investment agents in both types of carbon markets are expected

to possess any amount of wealth, which is also a reflection of the size of their respective

firms. Taking wealth distribution as equal or Pareto introduces forecasting error, as

behavior of real market agents is not followed completely by the artificial agents in the

learning process or formation of trading rules.

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5.8.2 Changing P

The results of experiments by changing proportion of carbon assets of agents, performed

on the simulated markets, are given in Table 5.5. The numbers in parenthesis indicate the

rank in forecasting accuracy. From these results, it can be observed that both the

evaluation measures show better forecasting accuracy by the model when we consider

equal distribution for proportion of allowances for the compliance market of ECX.

However for the voluntary market of CCX, the performance using both the measures is

better for Gaussian distribution. In compliance markets, all the agents get equally

proportioned allotment of allowances by the regulator, depending upon their level of

emissions in the beginning of commitment period. So by taking equal distribution in

model, the performance is expected to be better, which is true in this case. However, in

Chicago market, there is no allotment of allowances by the regulator and the companies,

investors or the agents are trading purely on voluntarily basis and it cannot be intuitively

expected from all the agents to buy or sell an equal proportion of allowances. Gaussian or

the normal distribution seems to be most appropriate in this case and the results of these

experiments also confirm the same.

Table 5.5. Results of experiments for changing the proportion of

carbon assets

ECX CCX

Proportion of

carbon

allowances

Equal Gaussian Equal Gaussian

RMSE 0.032

(1)

0.089

(2)

0.064

(2)

0.029

(1)

MAE 0.013

(1)

0.056

(2)

0.073

(2)

0.038

(1)

Figures in parentheses indicate ranking of forecasting accuracy

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5.8.3 Changing N

The results of experiments performed for number of agents N are given in Table 5.6 for

the simulated market of European Climate Exchange (ECX) and in Table 5.7 for the

simulated market of Chicago Climate Exchange (CCX). Keeping in view the results of

first two experiments, initial wealth distribution is kept as Maxwell-Boltzmann for both

the markets; and allowance proportion is kept as equal for the artificial market of ECX

and Gaussian for the artificial market of CCX.

From Table 5.6 relating to artificial carbon market of ECX, it is apparent that forecasting

performance using both the measures of accuracy improves continuously with the

increase in number of agents. As EU carbon market is in practice since 2003 and due to

fixation of emission reduction targets and the stringent implementation of rules in

Europe, the number of agents have increased to a considerably high level. As a result,

forecasting accuracy of agent based model is also the highest, when we consider their

number N as 100000. This is a positive indication for forecasting of compliance carbon

market for future also, as more and more agents are getting involved in the process of

carbon trading.

From table 5.7, for Chicago carbon market, the results depict that forecasting accuracy

improves first, as N is increased from 5000 to 25000; however, the same decreases

continuously as we further increase N to 50000 and finally to 100000. These results

again appear to mimic reality of Chicago market, which is a voluntary market so far and

Table 5.6. Results of experiments for changing N in ECX

N=5000 N=25000 N=50000 N=100000

RMSE 0.097

(4)

0.068

(3)

0.013

(2)

0.002

(1)

MAE 0.059

(4)

0.037

(3)

0.008

(2)

0.004

(1)

Figures in parentheses indicate ranking of forecasting accuracy

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number of participants, who make investment in the same, is neither too small nor too

big.

Table 5.7. Results of experiments for changing N in CCX

N=5000 N=25000 N=50000 N=100000

RMSE 0.085

(3)

0.027

(1)

0.054

(2)

0.098

(4)

MAE 0.062

(2)

0.043

(1)

0.067

(3)

0.120

(4)

Figures in parentheses indicate ranking of forecasting accuracy

5.8.4 Comparison with analytical models

Preceding discussion focused on the capabilities of agent based models in forecasting

carbon markets and experiments to improve accuracy of results. However, from an

investor’s point of view, it would be advisable to draw a comparison between the agent

based models and analytical models for forecasting purposes. In Chapter 4, it was proved

that GARCH (1, 1) and non-linear GARCH models give maximum accuracy for

forecasting the spot markets of ECX and CCX, respectively. Hence in this section, a

comparison of agent based model and the respective analytical model is made for both

the markets.

First, the forecasting of ECX spot market is done with GARCH (1, 1) model given.

GARCH (p, q) process is defined as

tttr εσ= ; ∑∑ = −

=

−− ++=Ω≡p

j jtj

q

i

itittt uuE1

2

1

2

01

22 )( σδαασ (5.15)

where 1⟨+ δα and δj > 0 for all j=0,1,….p.

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Forecasting accuracy is derived using both RMSE and MAE and the results are given in

the first column of Table 5.8. In second column the forecasting results from agent based

model in Table 5.4 are reproduced for comparison.

Table 5.8. Results of forecasting ECX spot market with GARCH

(1, 1) and ABM

GARCH (1, 1) Agent based model

RMSE 0.378 0.092 (4.1)*

MAE 0.213 0.075 (2.8)*

* indicates the number of times ABM is more accurate than GARCH (1, 1)

A comparison of the values in the two columns of Table 5.8, indicate that forecasting

accuracy of agent based model is higher than the corresponding analytical model for

ECX spot market.

Second, the forecasting of CCX spot market is done with non-linear GARCH model. N-

GARCH (1, 1), which is given as:

tttr εσ= ; 2

11

2

111

2

1101

22 )()( −−−− +++=Ω≡ tttttt HuuE σδσβαασ (5.16)

Where α1>0 and H1 is increasing function. Forecasting accuracy is again derived using

both RMSE and MAE and the results are given in the first column of Table 5.9. In second

column the forecasting results from agent based model for CCX in Table 5.4 are

reproduced for comparison.

A comparison of the values in the two columns of Table 5.8, indicate that forecasting

accuracy of agent based model is higher than the corresponding analytical model for

ECX spot market also.

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Table 5.9. Results of forecasting CCX spot market with NL-

GARCH and ABM

NL GARCH model Agent based model

RMSE 0.575 0.086 (6.7)*

MAE 0.238 0.067 (3.5)*

* indicates the number of times ABM is more accurate than NL-GARCH

From both the tables 5.8 and 5.9, it is clear agent-based models have got more potential

for forecasting purposes than mathematical models used in finance. In addition, there is

no scope of improving forecasting accuracy in traditional econometric models. However,

in agent based models, by varying the model parameters and agents’ characteristics by

way of experimentation, forecasting accuracy can be considerably increased; which

means that artificial carbon markets simulated by means of agent based models can be

made to mimic real world markets as close as possible.

5.9 Summary and conclusions

One of the major challenges for carbon market investors is to understand and forecast the

prices of carbon assets. However due to involvement of various heterogeneous agents in

the market mechanism, standard analytical models do not seem to provide reliable

forecasting tools. A solution to this problem is found in the world of agent based models.

A genetically-programd agent based model is found to satisfy the stylized facts of the

compliance market of European Climate Exchange (ECX) and the voluntary carbon

market of Chicago Climate Exchange (CCX). Further, the forecasting capabilities of

agent based models are found to be considerably better than the analytical models. This

could be due to the fact that behavior of heterogeneous trading agents in incorporated

well in these models, which is not possible in the traditional mathematical models. In

traditional models, there is no scope of improving forecast accuracy. However, in agent

based models, it is considerably improved by changing model parameters and agent

characteristics by way of experimentation. Three model parameters are changed: wealth

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distribution of agents; distribution of carbon assets as proportion of their total wealth; and

the number of agents in the artificially generated markets of ECX and CCX. Forecast

accuracy is found to increase considerably, when the parameter distributions or values are

close to the real market situations.

These results indicate that agent based models provide a very promising tool to

understand the price dynamics in carbon markets and obtaining high accuracy forecasts

as compared with the traditional econometric models. This study further opens doors to

many research directions. Carbon markets are a recent phenomenon and more and more

carbon markets are coming up in all parts of the world. One obvious extension of this

work is to apply agent based model to other markets for forecasting as the new data

becomes available from different parts of the world. Some of the most challenging

research concerns microstructure of carbon markets (Madhavan 2000), which could be

studied within artificial carbon markets. Going further, different groups of carbon market

participants like electric utilities, forest owners and transporters etc. can be clubbed

together and inter-group dynamics of market can be explored. In addition, the behavior of

fundamental trading agents can also be incorporated using the data of marginal abatement

cost from various industries. In addition, the experiments in this study have focused so far

on three parameters only, keeping others fixed. Future work may also include variations

in other parameters also, so as to have a bigger picture on the market behavior in carbon

trading. Nonetheless, the experiments carried out in this chapter being of pioneering

nature can work as a starting platform for further research in the use of agent based

models in understanding and forecasting of carbon markets in the times to come. Apart

from these issues, only price variable has been included in this chapter due to data and

software limitations. With advancements in the available softwares in the near future,

volume variable can also be included. Similarly efforts could be directed towards

incorporating policy level decisions in the model to incorporate strategic variables in the

model. Quoting LeBaron (2000), “this field is only in its infancy and much remains to be

done”, further improvements could be made in computation capabilities also by making

use of high level programming codes in high level languages, for example, Java and C++,

to have a better picture about use of agent based models in CO2 emission trading markets.

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6 Conclusions, Policy Implications, Limitations and Future Work

6.1 Conclusions

Forests play a major role in setting the CO2 levels in the atmosphere through carbon

sequestration. Carbon markets are one of the most innovative and cost-effective means of

creating a market pull for forestry credits generated through afforestation and

conservation activities. Due to increase in quantum of carbon trading over last few years,

various issues related to price dynamics of carbon markets have arisen in the recent past.

First, carbon markets have emerged at regional, national and international levels and are

governed by specific demand and supply patterns. There is a need to unify these markets

to increase overall carbon market efficiency. Second issue relates to understanding of

short-run volatility of carbon markets, as forecasts of carbon price volatility could be

important inputs into macro-econometric models and market risk assessment calculations

like value at risk and; for the choice of a carbon policy instrument. Third, carbon markets

consist of various heterogeneous agents such as greenhouse gas emitters, agriculturists,

foresters and individual market investors. These agents interact with each other and with

the overall trading-environment to evolve the emergent behavior of these markets.

Traditional approach for study of price dynamics in such markets is through use of

analytical models that assume completely rational agents. This causes biased results and

lesser forecast accuracy. To improve forecast accuracy, there is a need to carry research

on incorporating agent heterogeneity and limited rational behavior.

This research is therefore carried out in the form of three essays and economic analyses

are conducted on world’s carbon markets to examine these issues. Both compliance

markets of EU and voluntary market of North America have been covered in analyses.

The first essay addresses long-run integration of carbon markets at the interregional level

using Johansen full information maximum likelihood procedure for testing co-integration.

The second essay evaluates the performance of various econometric models for

predicting price volatility of carbon in different markets. In the third essay, an agent

based model of carbon markets is analyzed and the statistical properties of the artificially

simulated carbon markets are explored. The agents are sophisticated genetic

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programming based computer programs that co-evolve with learning by predicting

investment opportunities in the market using technical analysis as the main tool.

Experiments are performed on endogenous artificial markets to improve forecasting

accuracy of the model. The major conclusions of these analyses are:

First, the allowance-based carbon markets across North America and EU are not

cointegrated. A possible cause could be the fact that in EU countries, carbon market

investments take place on account of compliance under Kyoto targets; whereas in North

America, investors are trading in carbon markets purely on account of their

environmental responsible behavior or for anticipated fixation of targets in future. In

addition, international protocols like the Marrakesh Accords require that for compliance

purposes in EU, carbon credits could be used only from the Kyoto signatory nations,

which excludes the US based carbon markets. Due to lack of cointegration between EU

and North American carbon markets, an overall inefficiency is introduced in the system

and emissions cannot be reduced at the least possible cost.

Second, allowance-based markets within North America are cointegrated with each other.

This implies a common stochastic trend in the North American carbon market and could

be the result of spatial proximity and uniform regulatory mechanism so far. This common

trend could bind all these markets together and forecasting of prices in any of these

markets can be enhanced significantly by utilizing information from the prices of another

one. The traders, on account of perfect information, can gain potentially through

equalizing transaction costs in the unified North American carbon market. However,

recently, within North-American carbon markets, there is an indication of switching of

some buyers, specifically Canadian buyers, from the US markets to the Canadian market

due to establishment of Montreal exchange, as the firms now have an option to trade in

either of them. In the long-run equilibrium, if more firms trade in the US markets, leading

to increase in prices in the US markets, the Canadian market will face less demand and

therefore prices will decrease or vice-versa.

Third, CDM project based CER markets in Europe and USA are cointegrated because of

the fact that these credits are generated primarily in the developing countries and

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irrespective of the trading countries; their prices show co-movement around the world.

This indicates efficiency and existence of a global carbon market for CDM projects.

Looking at the specifics, the types of projects eligible for generating CERs in ECX and in

CCX are not similar. As a result, the situation market might change in future, if attempts

are not made either to link or to make both the markets homogenous with respect to type

of projects. Nonetheless, the development of global carbon market for CDM can be seen

as one manifestation of improved expectations for ensuring carbon sequestration and

sustainable development in the developing countries.

Fourth, for future, it is expected that new carbon markets coming up in different parts of

the world such as Australia, China, India and other countries, might not be co-integrated.

Such phenomenon could be due to different compliance requirements for different

countries and regions under international protocols, different sets of institutional

arrangements at the local levels, different expectation levels for environmental

sustainability and also due to restrictions on participation of buyers from other countries

and regions. The possibilities of arbitrage across the global markets will hence be limited,

and the carbon trading in these markets are expected to be globally inefficient in future.

Therefore, there is a strong need of a global agreement that allows global carbon trade to

prevent climate change at the least cost options.

Fifth, voluntary market of Chicago is more volatile than the compliance market of EU.

However, despite the various policy level changes, the time-series data for short term

volatility in both the markets follow a stationary pattern and hence volatility can be

forecasted for both of them. This could be helpful for carbon market investors, as they are

trading on the basis of daily price fluctuations, which are represented best by the

volatility.

Sixth, different carbon markets witness different volatility patterns and hence separate

econometric models are required for forecasting volatility for each of these markets. The

volatility behavior of voluntary market of Chicago is quite similar to that of other

financial markets and energy markets like oil and natural gas, which are all forecasted

well by complex non-linear GARCH models. Whereas, simple models like Historical

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averages and GARCH (1, 1) perform the best for compliance bound EU market, thereby

indicating different behavior of compliance carbon market from the voluntary carbon

market and other financial and energy markets.

Seventh, genetically programd agent-based models have considerable potential in

understanding the price dynamics of CO2 emission trading markets. These models

possess much better forecasting capabilities than the traditional econometric models. The

artificial carbon markets obtained from such agent based models generate features which

are remarkably similar to those from the actual data. Experiments performed on

artificially simulated carbon markets show that changing parameters of the model could

be adjusted to further increase the forecast accuracy, which is not possible in the world of

analytical models.

6.2 Policy Implications

Some policy implications are drawn from these analyses:

First, the effects of inter-continental CO2 allowance trade, particularly across Atlantic are

limited so far, and hence the market power1 of regional credit suppliers is large (Vatiero

2010). An important policy intervention could be to allow establishing links between

different countries, irrespective of their Kyoto commitments to tackle climate change

through use of markets. It will provide better opportunities to the traders and also result in

unification of allowance prices in the two continents. The result could also be used for

convincing the North American countries to fix emission reduction targets, as it will

bring efficiency in overall global carbon trading mechanism.

Second, as the CDM project markets are cointegrated and reflect efficiency, a policy

level decision could be taken to boost the CER market to further promote the CDM

projects, as they have an additional virtue of ensuring sustainable development in the

1 Market power is the ability of a firm to alter the market price of a good or service. In perfectly

competitive markets, market participants have no market power.

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developing countries. Developed countries should continue to improve the investment

environment and enhance incentives for these projects in the developing world.

Third, markets which are not integrated show inefficiencies and policy level changes are

required in the structure and design of the individual trading schemes. A policy level

initiative would be to link such emission trading mechanisms so as to integrate them in

the long run.

Fourth, understanding the short-term volatility dynamics might enable companies to

monitor the costs of CO2 emissions in their production process. At firm level, it could be

useful in deciding about banking and borrowing of the carbon credits as these options

allow firms to smooth emissions over time, which in turn smoothes the price of

allowances and increases certainty and thus investment.

Fifth, the study of volatility dynamics may be helpful in choosing between carbon tax and

the market based instruments at the policy level. Drawing comparisons between the

forecasts of various carbon markets with expected returns from a carbon tax, the policy

makers can have a choice to go for either or a mix of the two. Knowledge of volatility

behavior in different markets also presents policy makers an ability to choose from

different mechanisms to reduce uncertainties: To allow banking of allowances for future

use for motivating firms to further reduce their emissions now by allowing them to

establish a reserve for the future; or to allow firms to borrow allowances from future

periods; or to set price floor and/or ceiling to reduce the risks to investments in emission

reductions.

Lastly, the agent based models could be used to draw comparison between not only the

price dynamics, but also for choice of policy instruments, as they are shown to possess

better forecasting capabilities through incorporation of agent behavior, heterogeneity and

limited rational behavior.

6.3 Limitations and Future Work

While economic analyses in this research provide useful results related to price dynamics

of world carbon markets, they suffer from some limitations.

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First, the number of co-integrated markets is not a true measure of the degree of market

integration; that can be only assessed by measuring the reaction time to remove

disequilibria from the cointegrating relationships. Similarly, Johansen’s multivariate

cointegration procedure does not take into account the transaction costs, the marginal

abatement costs and other charges associated with carbon trading; and therefore is not a

very reliable method for analyzing the efficiency of arbitrage between the two markets. In

addition, only univariate price equations have been considered, whereas, volume of

trading can also be taken into account while exploring market integration. Future research

should include more assets from other carbon markets of the world and the enhanced

aspects of market integration. New research should not only confirm or contradict the

present results, but also try to resolve such issues by using further econometric analysis

and looking at more recent developments in the international carbon markets using more

extensive data series coming from newly emerging carbon markets.

Second, this dissertation is one of the pioneering studies pertaining to economics of

world’s carbon markets and hence is limited to examination of only price variable. All

the models considered belong to the univariate time-series family of carbon prices, and

examination of multivariate models that may include traded volume might bring some

changes in the results. Environmental variables like weather patterns and financial

variables like the number and type of listed companies on the climate exchanges and

policy issues like mandatory fixing of emission reduction targets by the federal or

provincial governments in the EU and US can further improve the accuracy of results.

Third, different carbon markets became functional at different points of time and hence

slightly different time horizons have been used in all the analyses. Accuracy of results

might improve after passage of more time, as the markets get mature.

Fourth, more trading options have been introduced recently in both EU market and in

Chicago Climate Exchange. An array of additional financial instruments-options,

derivatives and swaps are becoming available in different carbon markets around the

world. Their comparison will be desirable in future to get a more comprehensive picture

of the world carbon markets.

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102

Fifth, an extension of agent based model could be made to other carbon markets for

forecasting as the new data becomes available from different parts of the world. Different

groups of carbon market participants like electric utilities, forest owners and transporters

etc. can be clubbed together and inter-group dynamics of market can be explored. In

addition, the behavior of fundamental trading agents can also be incorporated using the

data of marginal abatement cost from various industries. Experiments on artificial

markets have focused so far on three parameters only, keeping others fixed. Future work

may also include variations in other parameters also, so as to have a bigger picture on the

market behavior in carbon trading. Similarly efforts could be directed towards

incorporating policy level decisions in the model to incorporate strategic variables in the

agent based model. Further improvements could also be made in computation capabilities

also by making use of high level programming codes in high level languages, for

example, Java and C++, to have a better picture about use of agent based models in CO2

emission trading markets.

Lastly, no structural breaks have been observed in data in most of the data, which shows

that policy level changes so far did not have very significant effect on the price dynamics

of these markets. However, with significant policy level changes at Copenhagen and

Cancun meets of UNFCCC, some structural breaks may arise in data in future, which

needs to be taken into account for further analysis.

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Appendix-1

Fig. A1. Genetic Programming Flowchart, adopted from Koza (1992)