The article in which this term paper seeks to evaluate is the creatively approached paper written by Eduardo Ortas who is an Associate professor of Finance at Zaragoza university alongside Igor Alvarez who is an Associate Professor at the Faculty of Economics and Business Administration of the University of Basque Country. The paper is titled “The efficacy of the European Union Emissions Trading Scheme: depicting the co-movement of carbon assets and energy commodities through wavelet decomposition.” (Ortas & Álvarez, 2016).
It is a paper which seeks to build on an emergent literature which is focused on understanding the efficacy, alongside the efficiency of the European Union’s emission trading scheme. This paper is focused on seeking to further develop a thorough understanding of the ways in which carbon assets and energy commodities prices interact through the deployment of a wavelet decomposition approach. The application of this methodological framework, which this review explores in further detail below, signifies a key factor in what differentiates this paper from the broad bulk of papers contained in much of the literature. Whilst the use of an innovative methodological approach can bring to light recently unexamined aspects of the relationship between the variables of carbon assets and energy commodities, they must also be considered with caution, the applicability of the findings and indeed to the ways in which these findings can be interpreted within the context of influencing policy making. Where the paper explores the particularities of the emission trading scheme it provides a clear insight into how the scheme functions in achieving its carbon emission reduction objectives.
The contextual backing for this paper lays in the development of the EU carbon market in 2005, following the adoption of an EU climate policy in 2003 (Hashimzade, 2017). The emission trading scheme (ETS) in which this paper focuses on consists of 5 phases, and this paper focuses largely on phase 2 of this scheme, a phase in which the objective of the ETS was to greatly reduce the number of allocations available to industry and to begin the process of curbing carbon generation within the EU through effectively a cap and trade scheme. It is for this reason that a paper which focuses on advancing our understanding of the relationship between this ETS and more broadly on the relationship between carbon assets and energy commodities in diverse portfolios has particular relevance to furthering our understanding of the efficacy of the scheme in curbing emissions in general. The authors cite in particular the relevance of environmental systems thresholds being a driving factor in the need for such an ETS to drive the EU towards compliance with its international obligations under (for example) the Kyoto protocol, the logic flows that through the creation of allowances, which permit the right to emit one tonne of c02 into the atmosphere that the level of carbon emissions generated will not increase. This, as we will see through the literature review fails to take account of a number of factors both internal (the limited percentage of total emissions included in the scheme) and external (broader market forces impacting price fluctuations) the latter of which this paper goes some way to shedding light on and builds into an emergent literature exploring the interactions between the ETS and other market factors, however it fails to explore this factor with due caution.
Of particular interest within this paper, notwithstanding the findings which have particular relevance for policy making, is the application of a methodology which sets out to explore the relationship between what is termed carbon assets and energy commodities through an exploration of frequencies, and the divergent way in which the relationship between carbon assets and energy commodities interact over these frequencies. It is noted that these findings are particularly pertinent for fund managers and those who seek to function with a carbon assets market alongside developing a broad portfolio within an energy commodities market, this is not to discount the importance to policymakers, who seek to understand the price impacts of the ETS on energy commodities.
Background and significance,
The Emissions trading scheme, and more broadly the carbon market signify both a statement of intent with regards to the degree to which the EU is committed to addressing increasing carbon emissions generation, alongside a central pillar of EU energy policy. Its knock-on effects within other aspects of energy, specifically in the case looking at the role the ETS has on the energy commodities market signals a convergence of policy across a number of areas of energy. This journal article, whilst failing to articulate the drawbacks of the ETS scheme, and its rather muted effect on emissions due to its limited scope and failure to include more polluting sectors (Anger, Asane-Otoo, Böhringer & Oberndorfer, 2015, Laing, Sato, Grubb & Comberti, 2014) does begin to explore an incredibly complicated relationship that exists between policy interventions, the ETS in this instance, and more broadly the interdependence of many facets of energy markets in Europe in particular in the context of this paper, but as is seen by much of the findings contained within the paper, more generally internationally due to the, at time, outsized role played by the European Union and its impact on energy commodity markets internationally.
The context of the paper, as hinted at earlier, is with regards to the increased role played by the EU in influencing the energy policy direction of members states through the development and deployment of the emission trading scheme. The emission trading scheme operates within 31 countries in total (28 in the EU and Iceland, Liechtenstein and Norway) (European Commission, 2019) and as such has a significant role to play in pushing the countries included within the scheme towards a position of a lower carbon footprint, as evidenced by reduced carbon emissions. This paper, through it’s exploration of the relationship between carbon assets and energy commodities can go some way towards developing a greater understanding of the ways in which these markets forces interact, whilst there is a great deal of research on the efficiency of the ETS to lead to reduced emissions, an analysis of the ways in which the markets interact serve as an important constituent part of a well developed energy market in its totality which takes account of carbon generated, alongside energy commodity pricing which can lead to an increased or reduced use of particular energy commodities having further impacts on carbon emissions.
An understanding of the impediments to the functioning of a well developed market is an important grounding in which to evaluate whether the objectives of that market (and juxtaposed towards the orthodox objective of a market – i.e. increased profit), in this instance reduced carbon emissions are obtainable. By exploring the relationship between two markets it’s possible to develop an insight into the sustainability of the carbon emissions market, and indeed what the impact is upon other more established markets, in this instance looking at energy commodities markets. It is for this reason that this paper under study provides a strong framework in which to evaluate the carbon market and the ETS in the context of a crucial phase of its implementation, however a contextual grounding in the factors which had a strong impact on the phase under study is absent and serves to take away from the otherwise strong empirical basis of the paper.
Literature review of the topic
Due to the centrality of the emission trading scheme within the European Union’s climate policy and it’s it’s well documented impact upon energy prices across the countries which are involved within the scheme (Boersen & Scholtens, 2014, Bredin & Muckley, 2011) it is not surprising to find that the ETS is an area with a large literature devoted to the multitude of ways in which it impacts upon a number of variables relevant to energy economics and more broadly its utilisation as a policy instrument which enables the EU to meet its carbon reduction targets.
Of particular relevance to this paper, we will seek to place the academic paper “The efficacy of the European Union Emissions Trading Scheme: depicting the co-movement of carbon assets and energy commodities through wavelet decomposition.” within the context both in which it was written, specifically phase 2 of the emission trading scheme, alongside evaluate the observations contained within, and contextualise the findings in a broader understanding of the ways in which the ETS functions as outlined within the relevant literature.
Indeed building on the work of (Bredin & Muckley, 2011) a paper which was published during phase 2 it is possible to see the divergent as well as convergent expectations of the ETS, and specifically the increased volume of trading beginning to take place within phase 2 of the ETS and analyse the factors under consideration, for example whilst (Bredin & Muckley, 2011) points towards an increasing level of efficiency active within the ETS, we can see that this same understanding lends itself to the efficacy of the ETS as outlined in the paper under study.
An exploration of a core tenant of the paper under study, highlights a key flaw in the papers rationale that must be challenged, and indeed a number of authors, specifically (Böhringer & Rosendahl, 2009, Laing, Sato, Grubb & Comberti, 2014, Abrell, Rausch & Yonezawa, 2019) have. This is the issue of the nature of the scheme, and the ways in which it is implemented in practice, the authors state that distinct from the command-and-control regulation used previously, that the ETS is distinct from this process, however building on the work specifically of (Böhringer & Rosendahl, 2009) we can evaluate this argument and view whether the ETS truly functions as a market based intervention distinct from political economy considerations.
(Böhringer & Rosendahl, 2009) state that their “analysis implicitly indicates significant political economy forces behind EU climate policy, as both cost-effective and strategically motivated partitioning of national emission budgets are far off from the actual break-down between trading and non-trading sectors.” This is not to say that the ETS, and the argument put forward by the authors of the paper under study that a market based policy instrument is controlled centrally, indeed that’s a key tenant of the ETS, however the authors fail to take account of the strategic imperatives of individual member states which can serve to undermine the ETS through national action plans which are submitted with strategic factors in mind, and the failure to evaluate the political economy of the ETS serves to hinder the ways in which the conclusions contained within can be evaluated, this is specifically relevant given the conclusions about it allowing the EU to meet climate goals whilst much of the EU’s greenhouse gases are not included (reflecting strategic opt-outs) and the period under study being a period of broad economic contraction within the EU which can serve to lead to a reduction in carbon emissions.
Similarly when we begin to look at the role of carbon markets and energy commodity markets, we can see that the work of (Wen, Bouri & Roubaud, 2017) to a large part builds upon the work of the paper under study, and in particular points towards this very gap within the literature as being a flaw in understanding what they term “extreme market movements” being looked over, and go on to state that “One of the main findings to emerge from our empirical analyses is that investors in the European carbon market can use the weak dependence between carbon and some energy-related futures to build more efficient investment portfolios to prevent (extreme) investment risks.”. It is also important to note that the authors point in particular to the better performance of portfolios trading in carbon futures in phase 3 as opposed to phase 2 (the period under study in the paper “The efficacy of the European Union Emissions Trading Scheme: depicting the co-movement of carbon assets and energy commodities through wavelet decomposition.”). Whilst this is not surprising, it’s an important point with regards to providing a fair and accurate reflection of the shortfalls of the paper under study, namely that macroeconomic trends were very negative during the period examined, alongside increased volatility within energy commodity markets during this period which led to a particular set of circumstances impacting upon the replicability of the findings. We can also see the impact of this over-allocation of allowances and indeed the relevance of the political economy aspect with regards to the work completed by (Anger, Asane-Otoo, Böhringer & Oberndorfer, 2015) who, through an evaluation of the role of lobbying and again, strategic allocations specifically in the context of Germany highlight, the serious flaws which are not alluded to in the paper under study, of particular relevance is the impact the over-allocation had on allowance price, a factor which certainly had a knock-on effects for the core thesis of the paper under study namely that; “The over-allocation became apparent toward the end of the first trading period where the allowance price dropped to zero as allowances in excess supply could not be banked for use in the second trading period”. Building on from this we can also the distributional impact of costs borne for abatement being influenced by lobbying from energy intensive ETS sectors to non-ETS sectors to meet overall climate targets, while outside the objective of the paper under study, it does highlight the key challenges of evaluating the ETS in meeting national carbon emissions targets.
Indeed within the work of (Wen, Bouri & Roubaud, 2017), it is this over allocation of allowances which is seen as a factor which destabilized the ability of the ETS to function efficiently specifically during phase 2. The absence of an evaluation of these broader market forces, and their ability to skew interpretation of the results within the paper under study which prove the biggest challenge to the validity of the findings, go on to state, which is highly pertinent to the paper under study and it’s limitations in evaluating phase 2 of the ETS rollout with sufficient evaluation of the exogenous factors, the authors state that papers which seek to evaluate the scheme on conclusion of phase 2 “highlight the difficulty in teasing out the effect of the nascent policy relative to many confounding factors such as economic shocks and rising fuel prices.” it is this early stage evaluation of a scheme which is in still in an evolutionary process which creates significant challenges in utilising such evaluations in understanding future changes to how the scheme will work that serve as an important consideration when evaluating the paper under study.
Another central argument put forward within the paper under study which requires a more thorough evaluation is the recommendation of using carbon assets in diversification for portfolio managers, that is further explored in the work of (Laing, Sato, Grubb & Comberti, 2014) which specifically seeks to contextualise corporate investment and the role of the ETS in promoting corporate investment within the ETS to clean energy, however this is seen as difficult to estimate during phase 2 due to the effects of the financial crisis and it’s knock-on effects on investment, this can lead to a position whereby a correlation or relationship may appear to exist, or not too exist during phase 2, but it’s difficult to ascribe credit (or blame) this on the role of the ETS, and for this reason the scheme’s impact may not be as clearly linked with diversification in portfolios as assumed in the paper under study, however when we begin to explore papers which take a more longitudinal view, we begin to see these findings being fleshed out – in particular we can see this within the work of (Wen, Bouri & Roubaud, 2017).
Critique of the Methodology
The methodological approach used within the paper under study, is a relatively unique approach taken within the context of that which is used generally and in particular focusing on emission trading schemes. The authors however do seek to build on the work of (Sousa, Aguiar-Conraria & Soares, 2014) and in this, they develop the methodological approach used in the work of (Sousa, Aguiar-Conraria & Soares, 2014) in the context of the ETS. The authors state that the approach they use “constitutes a very promising tool as it provides a refinement in terms of analysis where both time and frequency domains are taken into account”. The authors cite their objective to capture nonlinear dependencies within energy markets, alongside the objective of ensuring that energy prices in different energy markets which are frequently nonstationary are reflected in their analysis, the authors go on to state that this being a key feature of wavelet analysis affords them the space to conduct an investigation into the relationship between these variables with both of these criteria satisfied. The authors list the primary methodological approaches used within similar studies and we can see these approaches throughout the literature review. These approaches are Vector Auto-Regressive (VAR), Markov-switching, multivariate GARCH and jump-diffusion, we can see the use of the GARCH approach within (Bredin & Muckley, 2011) for example. The use of wavelet decomposition in this context allows a more thorough analysis within the frequencies of the period under study, and does indeed provide some insight across these frequencies as to the nature of the relationships of carbon assets and energy commodities, and lends itself to the being able to provide insight into forecasting based on time-series data (Zhang, Gençay & Ege Yazgan, 2017).
However as evidenced within the literature review, and with post ex-post and indeed some ex-ante evaluations of phase 2, it’s clear that this methodological approach faces considerable push back. As mentioned in (Laing, Sato, Grubb & Comberti, 2014) during any analysis of phase 2 there was a considerable “elephant in the room” which the methodology, though sought to discount by stating that such nonlinearities such as “unstable episodes in financial markets” were factors they sought to discount from their analysis, it’s important to emphasis the importance of the financial crisis and the Euro crisis had on economic activity (which may naturally reduce carbon emissions due to decreased production & consumption) and also the over allocation of allowance leading to an imperfect market. The methodology employed in this instance failed to take account of significant factors which impeded upon the applicability of their work and more specifically on the reliability of their findings.
Results and Discussion
In general, the results do match much of the literature namely that the emission trading scheme, whilst containing many flaws specifically in phase 1 and phase 2 (over-allocation of allowances and exogenous market factors in particular) does lead to an increased price for more dirty methods of production and incentivises production that is less carbon intensive, this is the conclusion which is outlined within (Kanamura, 2016 Wen, Bouri & Roubaud, 2017 and Bredin & Muckley, 2011) We can also see this within (Schleich, Rogge & Betz, 2008) which outlines that changes from phase 1 to phase 2 (specifically a tightening of allowances) is set to lead to increased energy efficiency returns thus having the desired effect of reducing carbon emissions within the countries involved in the emissions trading scheme.
More specifically however with regards to the relationship between carbon assets and energy commodities we can see a similar conclusion is drawn in the work of (Wen, Bouri & Roubaud, 2017) which outlines that hedged portfolios are superior in increasing the risk-adjusted returns of carbon assets. Alongside the roles played by dynamic diversified portfolios which are considered to be the best for reducing carbon (downside) risk a conclusion which aligns with the work outlined in the paper under study, which states that “Our central results reveal that carbon assets and energy commodities present a changing lead/lag behavior at different frequencies. The energy commodities lead the European Union Allowances returns at medium frequencies, but the contrary was true for the highest investment horizons” this aligns with the objectives of the ETS in that during longer cycles the majority of firms that have not yet switched to cleaner processes must buy more carbon assets which will have the further knock-on effect of increasing prices and de-incentivising carbon emissions generation.
The article certainly seeks to build on an emergent literature within academic enquiries into the merits and indeed successes of the emission trading scheme, in this context the article seeks to develop a more thorough understanding of the impact and indeed relationship between the emission trading scheme and the effect on energy commodities. This holds particular relevance for fund managers who may need to understand this relationship to diversify risk involved in managing complex portfolios in the energy field. However what is of considerable interest within this paper is it’s impact for policymakers, not only just in the countries covered under the ETS but more generally, specifically as the prices of energy commodities have a wide impact on global markets and energy policy interventions globally. It is for this reason, that whilst more research is required in terms of an evaluation of the evolutionary nature of the ETS and it’s knock-on effects within energy commodities this paper can serve as a building block through which such an evaluation can be conducted, albeit with modifications which seeks to similarly evaluate the political economy aspects, alongside broader macroeconomic trends which can impinge upon the reliability of results, which is a key area of concern with this paper and the performance of the European Union’s Emissions Trading Scheme.
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