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The Connectedness of Energy (CO2) Allowances (EUA and

CER), Fuel Sources (Oil, Natural Gas, and Coal) and

Anirudh Iyer(1502025), Ankit Jain(1502027), Lokesh Ahuja(1502098) and
Ravi Gupta(1502149)

This draft analyses the relationship between the returns for carbon emission
allowance, electricity and conventional energy sources price (coal, oil and natural
gas), converging on the impacts of emissions trading for European Union markets.
This work displays that the effect of carbon emission allowance depends on the
energy combination of the country under analysis but it is not the only factor. Less
carbon limitation takes place in the European Energy Exchange (EEX) and
innovations in carbon emission are not strongly reproduced in electricity prices.
Keywords: CO2 emission allowance trading, Dispersion, Volatility,
Directional Volatility, Connectedness, Directional Connectedness, Energy
mix impact
Dispersion: It is a statistical term defining the range of expected value of a
variable. In financial terms dispersion is mainly used by analyst or investor to
measure the variability of the stock or portfolio based on investor sentiment and
market analysis. It actually indicates the change in price of stock/portfolio in near
future which implies the risk associate with it. Hence, dispersion is mainly used to
calculate the underlying risk of a portfolio or stock in near future.
Volatility: Volatility is a statistical quantity of the dispersion of returns for a given
security or market index. Volatility can either be measured by using the standard
deviation or variance between expected returns from that same security or market
index. Higher volatility index means the expected variability in the price of
portfolio/stock is high i.e. higher risk. Which indicates that the price of
stock/portfolio may fluctuate dramatically within short period of time. Lower
volatility index means the expected variability in the price of portfolio/stock is low
i.e. lower risk. Which indicates that the price of stock/portfolio may change
gradually within short period of time.
Directional Volatility: Volatility are of mainly of two types. One of them is
historical volatility and the other one is directional volatility. Historical type volatility
expresses its output value based on the historical data of stock, which completely
stats about the past historical trends. The chances of repeating history are very
less. So, in many cases the historical data are not as important for predicting the
future trends, because market may or may not repeat history again. While on the
other hand directional volatility is the volatility index based on the current market
data, market news, market rumours, investor sentiments etc. It basically considers
current trends to indicate near future possibility of market reaction. Hence, most of
the times for predicting the near future market trends directional volatility is being

Connectedness: Connectedness is actually the connection or correlation among

different market or stocks (in terms of finance). Here, connected study is important
because it gives us the idea of change in price of stock/commodities related to
connected stocks or commodities. The change in price of one commodity may
correlate to change in price of another connected commodity. This phenomenon is
defined as the connectedness.
Directional Connectedness: When we talk about the connectedness of two
different commodities, we only measure the scalar part of it. Here, in case of
directional connectedness we mention not just the value of correlation but we also
focus on the direction of relation. So it gets the idea of connectedness more clear by
not only stating the correlational value between two commodities but the direction
between them also. We will get the influencing and influencer commodity by
directional connectedness, which helps us to strategies our portfolio more risk
Greenhouse gas guidelines is expected to improve price competitiveness of the
currently expensive carbon efficient technologies & surge the costs of burning
conventional sources of energy. The measure is expected to slow down the pace of
climate change. Although the impact of such rule on secondary carbon intensive
goods and services is relatively well understood, the influence on the prices of
primary conventional sources of energy, like natural gas and coal is less clear. Yet
this issue is particularly significant for conventional sources of energy exporting
countries such as Australia, Canada, Russia, Middle East & for the rest of the world
that relies on carbon inefficient energy generation. A carbon liability is created upon
the release of CO2 into the atmosphere, and is not charged on the carbon content of
conventional sources of energy that can be possibly released through the process of
burning. In the short to medium term, substitution effects are anticipated to play a
major role in determining the effect of greenhouse gases (GHG) regulation upon the
prices of primary fuel sources. For example, natural gas will in many cases replace
coal as a fuel source that generates lower carbon emissions. However, a
complicating factor is that carbon charges also apply to Greenhouse gases
emissions created in the process of mining conventional sources of energy from the
ground, and that certain types of fuel are mined in countries that have carbon
regulation in place, while others originate in regions exempted from carbon controls.
This is likely to distort substitution effects, making them contingent upon the
geographic origin of substitute fuels, as well as on the logistic cost. In the long-run,
carbon efficient renewable power sources, such as wind and solar electricity, are
expected to become more cost-effective and widely used. Although this will reduce
the demand for conventional sources of energy, it may also increase their
attractiveness through lower prices, resulting from decreased demand, and spare
In this paper we try to establish the connectedness between Energy (CO2)
Allowances, Fuel Sources (Oil, Natural Gas, and Coal) and Electricity. We take both
EUA and CER prices to represent energy allowance prices in the market while fuel
and electricity prices are picked up straight from the energy indexes.
EU Allowance (EUA) is the official title of the carbon credits or pollution permits
traded in the EU Emissions Trading Scheme (ETS). Each EUA characterizes one ton

of CO2 that the holder is allowed to emit. Allowance units are freely assigned or
auctioned to members of the EU ETS and can then be sold or purchased through the
carbon market. Firms within the scheme must surrender EUAs equivalent to their
emissions at the end of each compliance period. Those businesses that emit more
carbon than their cap have to purchase extra EUAs, while those that manage to
reduce their carbon emissions below their cap are entitled to sell their excess EUAs.
Certified Emission Reductions (CERs) are a type of emissions unit (or carbon credits)
allotted by the Clean Development Mechanism (CDM) Executive Board for carbon
emission reductions achieved by CDM projects and verified by a DOE (Designated
Operational Entity) under the rules of the Kyoto Protocol. CERs can be purchased
from the primary market (bought from an original party that makes the reduction)
or secondary market (resold from a marketplace). At present, most of the permitted
CERs are documented in CDM Registry accounts only. It is only when the CER is
actually sitting in an operator's trading account that its worth can be monetized
through being traded.
In Europe there are more than twenty different energy exchanges. The most liquid
exchanges are the European Energy Exchange (EEX) in Leipzig and the Nord Pool
Spot / Nasdaq Omx Commodities in Oslo. The main markets within an energy
exchange are the spot market, for short-term trading, and the forward market,
where the physical delivery of, for example, electricity or gas takes place at a future
The issue of interdependence between carbon and conventional sources of energy
prices is examined in several papers. For example Bunn and Fezzi (2007) conduct
an empirical study of relationships between carbon permit prices and energy
sources. They find a statistically substantial relationship between the prices of
carbon allowances, conventional sources and electricity. Zachmann and von
Hirschhausen (2007) extend these findings by estimating asymmetric effects of
carbon allowance pricing on electricity prices in Germany, while Fell (2008) and
Chemarin, Heinen and Strobl (2008) also examined relationships between electricity
and carbon prices across several Nordic countries and France respectively.
Chemarin et al. find no short-run links between electricity and carbon, and conclude
that these two markets are not integrated. On the other hand, Fell (2008) the
carbon prices affect the price of electricity in the short-run and Alberola et al. (2008)
find that natural gas, electricity, and coal have a statistically significant concurrent
impact on the European CO2 allowances. Fell (2008) also finds a small optimistic
effect running from the price of carbon to the price of Nordic fossil fuel. A report by
the Nordic Council of Ministers (2008) finds carbon to be highly correlated with oil,
and less correlated with natural gas and coal, however do not conduct statistical
tests of these findings. Thus, the current literature provides some conflicting and
inconclusive evidence, and it appears that there is scope for more studies on the
This Paper intends to take the studies further and tries to establish the
connectedness of EUA, CER with fuel and electricity prices. We use the
connectedness measures proposed by Diebold and Yilmaz (2014) which allow us to
sidestep the contentious issues associated with the definition and existence of
episodes of fundamentals-based or pure contagion. Diebold and Yilmazs (2014)
methodology can be considered as a bridge between the two visions since
uncertainty is based on how much of the forecasting error variance cannot be

explained by shocks in the variable and volatility spill overs are examined using
useful information on agents expectations (which gauge the evolution of both
fundamental and market sentiment variables). Thirdly, as volatility tracks investors
perceived risk and is a crisis-sensitive variable which can induce volatility surprise
(see Engle, 1993), by measuring and analysing the dynamic connectedness in
volatility we will be able to examine the fear of connectedness expressed by
market participants as they trade. To sum up, in this paper we explore a new
challenging avenue of research, focusing our study on the analysis of
connectedness in World Energy markets volatility using Diebold and Yilmazs (2014)
methodology in order to fill the existing gap in the literature.
Literature Review
The European Union Emission Trading System (EU ETS) was established on 1st
January 2005 following the 2003/87/EC directive. It is one of worlds largest
emission trading schemes and a very integral part of the EU Climate policy created
along with Kyoto Protocol. Kyoto Protocol has set a target of cutting the 1990 CO2
emission levels by 8%. The EU ETS monitors emissions from the sectors that are
more energy intensive. Governments issue permits to large CO2 emitting
installations and their equivalent is traded as options and futures.
The energy sector remains to be one of the primary contributors to greenhouse
gases, global warming, climate change and other emission related phenomena. In
the recent times, air pollution and climate change has become a major concern
especially in the urban areas. Emissions trading has been introduced to address this
issue where parties are allowed to buy or sell emission permits and credits for
emission reduction of some specific pollutants. Different countries use different
sources for energy generation which include nuclear, coal and other renewable
sources. The primary means of generation for any country depends on its
geographical characteristics as a result of which energy policies in different
countries are different. These policies along with certain other climate factors and
conventional sources of energy costs decide the electricity prices.
Weather, fuel availability and costs along with economic development determine
the CO2 productions. Carbon allowances are currently traded in electricity
exchanges all across Europe and their price depends on Demand- Supply dynamics.
The EU ETS is developed as the first large scale carbon dioxide (CO2) emission
trading system in the world. It consists of three phases:
Phase 1 is pilot phase which ran from 205 to 2007. Phase 2 ran from 2008 to 2012
and phase 3 of the system ran from 2013 till 2020. The EU ETS will expire in 2020, if
there is no consensus reached in internal climate. If any company wishes to
participate in the emission allowances market, it has to open an account in the
registry of its origin country as per the allocated stipulations. The EU ETS spreads
across 12,000 industrial installations and covers around 25 plus countries; Every
country involved has to propose its national allocation plan (NAP) including the caps
on greenhouse gas emissions for power plants and other sources. The national
allocation plan (NAP) must be approved by the European Commission. Total quantity

of carbon dioxide (CO2) allowances granted per year for each company and for
committed period is determined by National allocation plan.
Alberola et al. 2008 paper talks about the compliance requirement in EU ETS. As per
the paper, The EU ETS is a cap-and-trade scheme. There is an upper cap limit on the
overall level of emissions and any installation which fall short of allowances with
respect to its allocation level may purchase allowances in the spot market so as to
meet its regulatory requirements. Installations that are not able to meet their target
in Phase II have to pay a penalty of 100 /ton of CO2, as compared to penalty of 40
/ton in Phase I.
In the Ellerman et al. 2010 paper, At the beginning of Phase I, Initial amount of
permits were allocated to all the major emitters and they were allowed to trade
them on the open market. Every year, a similar new supply was given to same
sources, though the initial environmental benefits were limited because of over
allocation concerns among member states.
Koenig et al. 2011 paper talks about modelling the correlation in carbon and
conventional energy markets. That paper discussed correlations between daily
returns of monthly-ahead baseload electricity, conventional sources input and
carbon emission allowance (EU-ETS) prices. The viewpoint of a power plant operator
is assumed, producing baseload electricity with conventional sources and carbon
allowances and selling output forward in the future market. Price correlation
between electricity, conventional sources and carbon emission allowances as well
as their dynamic pricing behaviour is critical for the degree to which cashflows from
plants are hedged. Switching between input fuels with different carbon intensities is
taken as the fundamental driver of this correlation. Using daily observations of
future prices, the results suggested that extreme climate, high commodity market
volatility have no effect on correlation. However, there is indication of noteworthy
price decoupling during phases of extreme relative carbon emission and fossil fuel
To Identify the carbon price patterns researchers studied the dynamics of price
information flow between the German electricity prices and gas, coal, oil and wind
power in Germany. The Creti2012 paper focussed on the carbon future price
determinants in Phase 2 by trying to find the relationship between energy prices
and economic indicators. Although weather variable were not included in the study
as it was assumed that according to the existing research, its impact on carbon
prices was only indirect and thus appear in form of sudden shocks.
Emission permits for carbon have an opportunity cost equal to their market price.
While talking about the cost of electricity, the cost of carbon would thus be an
addition and must be included in the costing. Although technology and other
efficient practices might affect the aggregate effect of the carbon price. In order to
give incentives for reducing emissions, trading allowances are given for emission of
CO2. The resulting market as an asset value of Billions of Euros annually.
CO2 Trading is different from the conventional commodity trading due to the
following reasons :-

1. People who emit more than the allocated levels can buy the allowances from
the Sellers who emit less than the allowed levels.
2. The Carbon Credit system exists which offers motivation to countries to keep
their emission levels below the allocated levels in the form of various
3. As far as stocks are concerned, a firm can decide the number of shares to be
issued whereas in the CO2 trading system, the annual quota of emission
allowances is given and controlled by the EU-Directive.
4. The Prices of Allowances depend upon the supply and demand balance
whereas value of stocks are determined by the expected profits of the firm
that distributes shares.
5. The Emission trading market has only the government that acts as the lone
source of allowance and emission permits
6. Allowances have a limited validity.