'Politics as (un)usual’: Political Events and Market Fluctuations in the European Union Emissions Trading System

Abstract

The European Union’s emissions trading system (EU ETS) was constructed under an imperfect political process and already experienced substantial iterations upon the initial design. This paper examines to what extent the political nature of the artificial emissions market creates exogenous shocks in spot prices and structural breaks in implied volatility trends, and to what extent pricing models can accurately price options on European Union Allowances (EUA) futures contracts. It concludes that the EU ETS in Phase III, despite previous political failures in managing the system, is not subject to more exogenous shocks to spot prices than developed blue chip and energy stock markets, though certain political events intuitively result in unique structural breaks in implied volatility time series. Finally, it determines that pricing models which account for stochastic volatility offer the most predictive power for firms operating under imperfect information, and ends with conclusions for emissions trading in other parts of the world.