The puzzle of Carbon Allowance spread

TL;DR

This paper explains the persistent spread in the European carbon allowance market by linking it to corporate credit spreads, suggesting policy changes to improve market efficiency and support the EU green transition.

Contribution

First to attribute the EUA market anomaly to corporate credit spreads and demonstrate its cointegration with risk-free rates, informing policy solutions.

Findings

C-spread is cointegrated with credit spread and risk-free rate

Including EUA in ECB collateral could reduce market anomaly

Policy change can support EU green transition

Abstract

A growing number of contributions in the literature have identified a puzzle in the European carbon allowance (EUA) market. Specifically, a persistent cost-of-carry spread (C-spread) over the risk-free rate has been observed. We are the first to explain the anomalous C-spread with the credit spread of the corporates involved in the emission trading scheme. We obtain statistical evidence that the C-spread is cointegrated with both this credit spread and the risk-free interest rate. This finding has a relevant policy implication: the most effective solution to solve the market anomaly is including the EUA in the list of European Central Bank eligible collateral for refinancing operations. This change in the ECB monetary policy operations would greatly benefit the carbon market and the EU green transition.