Role of carbon swap trading and energy prices in price correlations and volatilities between carbon markets

The present paper theoretically and empirically examines the role of carbon swap trading and energy prices in volatilities and price correlations between the EU and Kyoto Protocol emissions trading schemes. A supply and demand based correlation model between EUA and sCER price returns is proposed in detail using inverse Box-Cox type marginal abatement cost (MAC) curves and simple emission reduction volume processes. The model includes financial players' EUA-sCER swap transaction in boom periods of carbon prices using the logit model for EUA and EUA-sCER swap volume correlations, and stronger energy price impacts on EUA prices than sCER prices using a mean-reverting lognormal process for energy prices. The empirical studies using EUA and sCER prices estimate the model parameters, resulting in a positive EUA volume impact on EUA-sCER swap transactions and a positive energy price impact on EUA prices. It is shown that high EUA-sCER price correlations during high EUA price periods stemmed from EUA-sCER swap transactions, whereas high EUA-sCER price correlations during the period of financial turmoil with low EUA prices came from the drop in energy prices. We also show that the leverage effects often observed in security markets exist in both the EUA and sCER markets according to the price-volatility relation.