Modelling Carbon Chaos: Understanding the Effects of Shocks on Carbon Allowances - A Study of Fundamental and Uncertainty Influences Through a Vector Autoregressive Model

Sammanfattning

The European Union’s Emission Trading System (EU ETS) is the EU’s primary decarbonisation instrument. The carbon emissions, referred to as European Union Allowances (EUA), are auctioned and subsequently traded between firms on a secondary market. We analyse how EUA prices react to fundamental (oil, gas, coal, economic activity, electricity) and uncertainty-related (Economic Policy Uncertainty, Climate Policy Uncertainty, Oil Price Uncertainty, Energy-related Uncertainty) variables, and whether there are discernible differences between the third (2012–2020) and fourth (2021–2025) phases. To examine these relationships, the study employed a two-variable Vector Autoregression (VAR) model and Impulse Response Function (IRF) to examine the relationships. Our findings indicate that the price of gas had a significant positive impact on the price of EUAs, while the price of coal had an insignificant effect. This suggests that the relative cost of emissions plays a crucial role in fuel switching an occurrence where companies transition between coal and gas. Oil price shocks had a positive impact on EUA prices during the third phase, but a negative effect during the fourth. We attribute this shift to the inclusion of maritime and transport sector in the fourth phase, and the reduction of free allowances for the aviation sector. These sectors rely heavily on oil, which strengthened the direct link between oil prices and EUA prices. Our findings also demonstrate that uncertainty variables can significantly affect EUA prices. These findings have important implications for policymakers seeking to design an effective system to support green transitions, as well as for firms and investors aiming to mitigate risks in the carbon market.