Financial Turmoil in Carbon Markets

Abstract

This article assesses the impact of financial turmoil on carbon markets. The carbon trading behavior aligned with security trading is incorporated into a model of the price-volume relationship. The model indicates that correlation increases when stock prices plunge, which is referred to as contagion. Empirical studies to estimate the model parameters for EUA futures prices, FTSE 100, and DAX suggest that the correlations between EUA and stock indices decrease with the stock indices, consistent with the existence of contagion driven by financial markets. High volatilities in both stock indices and carbon prices come from low stock prices, implying an absence of an inverse leverage effect not only in FTSE 100 and DAX but in EUA futures prices. More importantly, high volatility in carbon prices driven by low stock prices may represent the impact of financial turmoil on carbon price volatility. In addition, we show that the positive relationship between EUA futures prices and FTSE 100 or DAX indices for phase II of the EU-ETS is more enhanced than phase I of the EU-ETS. Moreover, we investigate the differences of the correlations between carbon prices and stock indices regarding the type of carbon assets, that is, EUA and CER. It is found that EUA correlates with FTSE 100 and DAX more strongly than CER on average. Finally, almost the same empirical study results are obtained using the correlations between EUA and FTSE 100 or DAX and using the volatilities calculated from the Engle’s dynamic conditional correlation model.