Theoretical Issues and Empirical Analyses
New Horizons in Environmental Economics series
Edited by Francesco Gullì
Chapter 6: A Vector Error Correction Model of the Interactions Among Gas, Electricity and Carbon Prices: An Application to the Cases of Germany and the United Kingdom
Derek W. Bunn and Carlo Fezzi INTRODUCTION 6.1 The European Emissions Trading Scheme (EU ETS), started on 1 January 2005, has been a substantial initiative of the European Union (EU) to fulﬁl its carbon abatement targets following the Kyoto Protocol. According to the ETS directive (European Commission, 2003), tradable allowances are allocated to industrial emitters of carbon dioxide, specifying the amount of CO2 they can emit each year. Since companies are allowed to trade permits freely with one another within the EU, the scheme should ensure not only that overall emissions are reduced, but also that the cuts are made by those ﬁrms that provide lower abatement costs. Therefore, the economic impact of reducing CO2 emissions should be minimized. Prior to the emergence of actual evidence from carbon trading in practice, extensive theoretical and simulation analyses have speculated upon its eﬀects, in particular on the energy sector (for example, Böhringer, 2002; Barreto and Kypreos, 2004; Böhringer and Lange, 2005). Although capable of providing normative and policy insights, these theoretical models are not appropriate for explaining carbon price dynamics on a daily basis. Indeed, as soon as the ﬁrst market data became available, empirical, econometric models were developed to explain CO2 price behaviour. For example, Mansanet-Bataller et al. (2007), using several regression models, identify weather and energy price variables (in particular oil price) as the main determinants of CO2 price changes during 2005. However, their analysis does not provide a complete picture of the interactions between energy...
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