Comparison of Futures Pricing Models for Carbon Assets and Traditional Energy Commodities

Abstract

This article explores the classification of carbon futures, often considered to be a type of energy commodity futures from the energy-emission relationship, by examining the characteristics of carbon futures prices. The author presents a carbon futures price model reflecting the observed price characteristics found in previous empirical studies. The empirical analysis of EUA (EU allowance) futures prices traded on the European Climate Exchange (ECX) show that convenience yield of EUAs is negatively correlated with EUA price returns, which corresponds to the characteristics of the model presented in this article. The author also reports positive market prices of risk (MPR) for carbon assets in both short- and long-term observation periods, finding them to be different from energy commodities where the long-termMPRs are positive and the short-term MPRs are negative. He also examines the conditional correlations between EUA futures prices for contracts with different delivery dates, finding almost positive correlations which cannot empirically produce backwardation as often observed in energy commodity futures markets. Moreover he shows that the price–volatility relationship possesses a leverage effect (that is, a negative relationship between futures price and volatility) often observed in security futures markets rather than energy commodity futures markets. In addition, empirical studies using EUA futures option prices traded on the ECX show that carbon futures prices behave unlike energy commodity futures but like security futures in terms of a volatility smile. These empirical results regarding carbon futures prices also support a carbon futures price model characterization that is more similar to security futures than to energy commodity futures.