European carbon market (2008-2011) price drivers analysis and applications to risk management – correlation and cointegration vs copula approach

Ieva Petruzyte

Student thesis: Master thesis


As part of the European Union key policy aimed at reducing greenhouse gas emissions (GHG) – European Union Emission Trading Scheme (EU ETS) was launched in January 2005. Following this initiation, a new investment asset was introduced to the market – European Union Allowance (EUA) – a right to emit a ton of CO2. The establishment of the European carbon system created a new type of risk – carbon risk, to which more and more companies and investors are becoming to be exposed. Despite the growing importance of the carbon market in investment and risk management, the available research of the topic remains limited. Although a handful lot of papers, investigating EU ETS Phase I, have been issued, the empirical research on Phase II remains scarce. The aim of this paper is to shed more light on the new structure of the market and different factors affecting market participants’ carbon risk, as well as provide a thorough analysis of their interdependency, and offer some insight for risk management purposes. By looking for a presence of a stochastic trend, Hotelling rule and cost-of-carry relationship we establish a methodology to check the efficiency of the EU ETS market. We conclude that current market setting is inefficient and intertemporal arbitrage opportunities are present. By implementing correlation, cointegration and copula methods, we conclude that EUAs futures are a suitable instrument to hedge away carbon risk. We propose implementation of copula approach in the calculation of Value-at-Risk metric as well as optimal hedge ratio for the sound risk management practices.

EducationsMSc in Applied Economics and Finance, (Graduate Programme) Final Thesis
Publication date2012
Number of pages92