Inefficiencies of Carbon Trading Markets

TL;DR

This paper investigates the European Union Emission Trading System as a financial market, revealing significant inefficiencies such as low trading activity, seasonal trading patterns, and speculative behaviors that undermine its environmental goals.

Contribution

It is the first comprehensive study analyzing the EU ETS as a financial market using detailed transaction data from 2005-2020, highlighting key inefficiencies.

Findings

Approximately 40% of firms do not trade annually.

Many firms trade mainly during surrendering months.

Presence of speculative trading exploiting private information.

Abstract

The European Union Emission Trading System is a prominent market-based mechanism to reduce emissions. While the theory is well understood, we are the first to study the whole cap-and-trade mechanism as a financial market. Analyzing the universe of transactions in 2005-2020 (more than one million records of granular transaction data), we show that this market features significant inefficiencies undermining its goals. First, about 40% of firms never trade in a given year. Second, many firms only trade during surrendering months, when compliance is immediate and prices are predictably high. Third, a number of operators engage in speculative trading, exploiting private information.