The aim of this research is to address the inter-phase informational efficiency of the European Union Emissions Trading Scheme (EU ETS) from 2005 to 2010. Using the weak-form Efficient Market Hypothesis (EMH) as the appropriate theoretical framework, the investability, dynamic linkages, and random walk behaviour of European carbon markets were collectively examined via the following Research Questions:
Are European carbon markets weak-form efficient?
Research Question One "What are the investment characteristics of European carbon markets?"
Research Question Two "Do dynamic linkages exist among European carbon markets?"
Research Question Three "Do European carbon markets follow a random walk?"
The empirical study employed a quantitative, time-series approach using 1,220 daily spot and forward price observations from the EU ETS across Phase I (April 2005 - December 2007) and Phase II (February 2008 - March 2010). Supporting price index data from European, American, Australian, and Chinese equity markets, and the European Central Bank (ECB) were also considered. Econometric procedures such as summary statistics, Pearson correlation coefficient tests, regression analysis, breakpoint tests and sub-period regression analysis, unit root tests, cointegration procedures, vector error correction models (VECMs), Granger causality tests, impulse response functions, and tests of the Random Walk Hypothesis (RWH) (such as serial correlation coefficient, runs, and variance ratio tests) were employed to address the Research Questions. Research Question One results showed that European carbon markets demonstrate significant price volatility, risk-adjusted return underperformance, positive correlations and statistical linkages with international markets (particularly the European stock market), and poor investability. The findings also imply that carbon markets are becoming more integrated with international equity markets, albeit at the expense of reduced diversification benefits and possible return predictabilities. Research Question Two findings revealed robust short-run dynamic linkages among spot and forward carbon prices in Phases I and II, indicating that joint price discovery is taking place in carbon markets. However, evidence of constrained long-run price transmission (as indicated by the joint short- and long-run Granger causality testing) may be problematic for weak-form market efficiency. Research Question Three results illustrated the possibility of non-random behaviour and short-term return predictability in spot and forward carbon prices (albeit with less magnitude in Phase II). Overall, the results suggest that European carbon markets are weak-form inefficient in Phase I but less so in Phase II.
If European carbon markets are "weak-form inefficient", policy makers should consider decisive policy reform/s to address the informational constraints facing the Scheme. Policy makers may also have to reconsider the sole use of carbon trading as the preferred global greenhouse gas (GHG) mitigation option, and instead flank market-based mechanisms with a diverse range of flexible, cost effective policy alternatives that can be scaffolded and policed across international borders. What is clear is that a global price on carbon must be established in a timely and an economically efficient manner, particularly if international trading is the chosen abatement mechanism and environmental preservation is deemed a priority.