A Study On The EU Carbon Market Dependence Structure And Risk Spillover Effect On Price Fluctuations Of Carbon Emissions

The Kyoto Protocol is designed to limit greenhouse gas emissions in developed countriesin order to respond to the challenges posed by global climate change. Cap-and-Trade of theKyoto Protocol becomes a new market tool to solve greenhouse gas emissions. The globalcarbon trading market based on carbon dioxide emissions was quickly set up and rapidlygrowing. Since the EU Emissions Trading Scheme (EU ETS) was established in2005, EUemission Allowance (EUA) market becomes one of the most liquid and influence emissionstrading markets in the world. However, the volatility of carbon price is severe. As a result, riskassociated with fluctuations in carbon price could spread through carbon markets. As carbonprice risk was quickly accumulated, it would give rise to systemic risk. This kind of marketvolatility transmission mechanism is known as risk spillover. Therefore, a research ondependency structure between EU carbon markets and their risk spillover effects becomesimportant for investors to avoid risk and for policy makers to explore the core of carbonmarket stability mechanism. China is the most large developing country but withoutmandatory emission reduction obligations. However, as the world’s largest emitter, Chinafaces enormous pressure to reduce emissions. While as the largest supplier of global carbonmarkets, China has to follow the biggest buyer(EU)’ pricing. Fortunately, China has beenactively exploring how to create a domestic carbon market to achieve emission reductioneffects and change an unfavorable position in global carbon markets. As we know, the EUEmissions Trading Scheme is the world’s most successful carbon market. So it need learnadvantages and disadvantages of EU ETS to establish domestic carbon market. In this paper,it mainly research EUA spot market and its derivatives markets dependency structure andtheir risk spillover effects, and hoping that the conclusion of this paper can help theestablishment of a domestic carbon marketIn this paper, firstly analysis and summarize the operating rules and the lessons of the EUemissions trading system. Based on using the GARCH model and the DCC-GARCH model,using the Copula Function and the extreme value theory to establish the Copula-EVT Model,building CoVaR indicators, and using six years of daily closing price data of carbon spots andcarbon futures within EU carbon market from2005to2011, empirical research on dependency structure and risk spillover effects of EU carbon spots and carbon futures markets.And then discuss how to establish a domestic carbon emissions trading market in China.The main conclusions are as follows:The EU emissions trading system is a new emissions trading market, it not onlyestablishes a price for emission rights, more importantly, but also gives a valuable upsideexpectations in the formation of future emissions assets for businesses and individuals.However, the carbon market price fluctuations, and rule-making for the development ofemissions trading market have a significant impact. To learn the success of the EU ETSexperience, it need study the boundary conditions and preconditions of effective operation indepth, and requirements for stage of development of the market economy and other factors,combining with their respective national circumstances and economic development features.Through use GARCH models to test the volatility of carbon prices, and find that there issignificant asymmetry in the first phase of the carbon market volatility, and its fluctuations inthe decay rate is faster than the second stage. Through analyzing its heteroscedasticitydiagram, find that extreme risk exist in carbon market.Based on the above analysis, using the DCC-GARCH model to describe the dynamicconditions correlation of EUA futures and spot yields from the first phase to the second stage,the dynamic correlation between EUA spots market and futures market is graduallystrengthening. It is not strong interactive relationship between EUA spots and futures marketsin the first phase, which maybe relate to the imperfect carbon market system in the first phase,there are barriers between the transmission of information between carbon markets. From thebeginning of the second stage, due to emission Allowance allocation mechanism maturing, thedynamic correlation between EUA spot market and futures market is becoming increasinglystrong, investors can take advantage of the correlation between volatility of spot and futuresfor effective hedging to avoid systemic risk.Through using extreme value distribution for the marginal distribution and constructingTawn Copula function, it greatly captures tail dependency between EUA spot market andfutures market in the second phase. It empirically shows that, in the second stage, taildependency was significantly higher during a boom than a downturn. When the carbonmarket is skyrocketing, yield of EUA spot and futures interact each other, mutually reinforce bilateral risk relationship. While it also can be used by BB7Copula function to portray, thisresult means that when extreme risk events happening such as carbon market is in decline,carbon market risk reinforced each other, it is a true for carbon market. Therefore, inparticular, it is extremely necessary to set a appropriate stabilization mechanism for thepre-sudden crisis of carbon markets, as possible not interfere normal market fluctuations andtransactions.Based on researching the carbon market dependency structure using Copula theory andextreme value theory, using conditions value at risk(CoVaR) to assess risk level of carbonfutures market when carbon spot market exists risk events. It shows that CoVaR can estimaterisk spillover effect. If using VaR to assess market risk, it would seriously underestimate risklevel of carbon futures market. For market regulatory authorities, it need only know that asingle carbon market risk spillover strength. That is, no longer rigidly adhering to a singlemarket risk regulation, they just have to focus on the potential risks of the entire carbonmarket system to guard against, control and mitigate systemic risk, and maintain a stablemarket environment, to promote carbon market healthy, safe and efficient operation.It is more important for China to establish a domestic emissions trading system.Combined with the findings of dependency structure and risk spillover effect between EUcarbon markets, this paper presented for the first time that it should be based on CERs futuresas a starting point, and then to establish carbon financial derivatives step by step in China. Itneed not only to pay attention to rationalize the relationship between the carbon spot andcarbon futures market, but also to establish risk prevention mechanism to prevent potentialrisk of carbon price fluctuations in order to achieve stability and security of the entiredomestic carbon market system.