What determines the price of carbon? New evidence from phase III and IV of the EU ETS

In this paper, we provide new evidence on the determinants of EU emission allowance prices by analyzing the most recent trading periods, i.e. phases III and IV. We consider energy (oil, natural gas, coal) and electricity prices using various modeling approaches. We find that none of the approaches that have been proposed in the early literature on carbon pricing is suitable to explain the allowance price in the most recent sample. Among the variables, crude oil and electricity appear to be the most important market fundamentals, as they explain the largest share of variance. However, the explanatory power of all variables diminishes over time. We find that market fundamentals are able to explain up to 12% of the variation of EU emission allowance prices in phase III. However, the explanatory power drops to below 1% in phase IV. We conjecture that as the EU Emission Trading Scheme matures and the emissions cap tightens, the economic mechanics have fundamentally changed.