The relationship between European electricity markets and emission allowance futures prices in phase II of the EU (European Union) emission trading scheme

• We investigate the drivers of carbon futures prices in Phase II of the EU ETS.
• Natural gas, oil and the coal-gas switch in power generation are the main price drivers.
• We also investigate different power exchanges.
• Market specifics play a distinctive role in carbon finance, esp. APX-UK and Nordpool.

We investigate how electricity markets relate to emission allowance prices. We analyze the price determinants of the European Allowance Units' returns and account for exchange specific effects. We employ a Threshold GARCH (Generalized Autoregressive Conditional Heteroskedasticity) model and, apart from the exchange specific analysis, introduce several energy specific variables in the analysis. As such we extend the work of other scholars. We find that natural gas, oil prices and the switching possibilities between gas and coal for electricity generation are significant drivers of the carbon futures price. This is because the price of electricity is partly determined by the cost of the fuel inputs, and these costs are affected by the CO2 allowance price. Furthermore, it appears that Nordpool and APX-UK spot prices have a profound impact on these prices. Therefore, another contribution is that we establish that local market specifics play a distinctive role in carbon price formation.