Variance risk premia in CO2 markets: A political perspective

The European Commission discusses the change of free allocation plans to guarantee a stable market equilibrium. Selling over-allocated contracts effectively depreciates prices and negates the effect intended by the regulator to establish a stable price mechanism for CO2 assets. Our paper investigates mispricing and allocation issues by quantitatively analyzing variance risk premia of CO2 markets over the course of changing regimes (Phase I-III) for three different assets (European Union Allowances, Certified Emissions Reductions and European Reduction Units). The research paper gives recommendations to regulatory bodies in order to most effectively cap the overall carbon dioxide emissions. The analysis of an enriched dataset, comprising not only of additional CO2 assets, but also containing data from the European Energy Exchange, shows that variance risk premia are equal to a sample average of 0.69 for European Union Allowances (EUA), 0.17 for Certified Emissions Reductions (CER) and 0.81 for European Reduction Units (ERU). We identify the existence of a common risk factor across different assets that justifies the presence of risk premia. Various policy implications with regards to gaining investors' confidence in the market are being reviewed. Consequently, we recommend the implementation of a price collar approach to support stable prices for emission allowances. (C) 2016 Elsevier Ltd. All rights reserved.