Carbon Risk in the Light of the Changing EU ETS

Abstract

The establishment of the EU emission trading scheme (EU ETS) has internalised climate change risk into carbon risk, to which companies are becoming increasingly exposed. Understanding the market is essential for good risk management. However, the many uncertainties present in the market are difficult to grasp and make it hard to quantify the risk. The main purpose of this thesis is to gauge the factors affecting the market participants’ carbon risk exposure of the and provide insight for hedging the carbon risk in Phase II and III of the EU ETS. The first part of this study analyses different uncertainties and scenarios in the carbon market and evaluates their impact for the future development is evaluated. Special attention is given to institutional factors as the most relevant risk drivers in the midterm perspective. In the second part, the cost-of-carry model is tested together with cointegration analysis between the European Union Allowances (EUA) and Certified Emission Reduction (CER) spot and futures prices, futures being the most liquid hedging instrument. The results here are mixed. While no cointegration can be proved with certainty in the case of EUA, the CER spot and futures are clearly cointegrated, although definitely not through a cost-of-carry relationship.