Carbon Price Drivers: An Updated Literature Review

1. Introduction

Ellerman and Buchner (2007) , and Convery and Redmond (2007) masterly produced an early literature review on the carbon price development in their respective articles for the first issue of the Review of Environmental Economics and Policy. This work was further elaborated by Convery (2009) alone in his reflections on the emerging literature on emissions trading in Europe, and compiled in an edited volume by Ellerman, Convery and De Perthuis (2010). Zhang and Wei (2010) provided further insights, based on evidence from the operating mechanism and economic effects of the newly created EU Emissions Trading Scheme (EU ETS).

Building upon these initial contributions, this paper provides a systematic update on the cutting-edge literature of carbon price drivers from 2007 onwards. It reviews mainly economic and econometric studies which have identified inter-relationships between the price of CO₂ on the one hand, and its main fundamentals that allow to explain and forecast its variation overtime on the other hand. By doing so, this paper calls for more research in this promising area, since many puzzles remain to be solved by researchers in empirical work, especially concerning the adjustment of carbon prices to the macroeconomic environment.

At first glance, this paper features that the price of carbon is classically driven by the balance between supply and demand, and by other factors related to market structure and institutional policies. On the supply side, the number of allowances distributed is determined by each Member-State through National Allocation Plans (NAPs), which are then harmonized at the EU-level by the European Commission. On the demand side, the use of CO₂ allowances is a function of expected CO₂ emissions. In turn, the level of emissions depends on a large number of factors, such as unexpected fluctuations in energy demand, energy prices (e.g., oil, gas, coal) and weather conditions (temperatures, rainfall and wind speed). The demand for allowances can be affected by economic growth and financial markets as well, but that latter impact needs to be further assessed in the academic community.

The remainder of the paper is structured as follows. Section 2 explains how institutional decisions affect the price path of carbon. Section 3 introduces the mechanisms at stake between the price of CO₂ and the price of other energy markets. In addition, it provides the main intuition behind the influence of extreme weather and temperatures events. Section 4 develops the links with the macroeconomic and financial markets. Section 5 briefly concludes.

2. Institutional Decisions

In this section, we consider two main categories of institutional decisions that are likely to impact the price of carbon: (i) the emissions shortfall factor, defined as the difference between verified emissions and allocated allowances within a given compliance year, and (ii) the effects of banning banking from phase I to phase II of the scheme.