Is the European Union Emissions Trading Scheme (EU ETS) informationally efficient? Evidence from momentum-based trading strategies

•This paper examines the informational efficiency of the EU ETS.•In particular, it examines momentum – a form of price predictability.•It applies a time series approach to momentum.•It finds that momentum exists which leads to profitable trading strategies.

Since 2005, the European Union Emissions Trading Scheme (EU ETS) has seen a rapid growth in trading volume activity, with 1.44 billion tons of CO2 traded in 2007. The total value of these trading transactions was €24.1 billion in 2007, confirming the EU ETS as the largest emissions trading system by transaction value. In this paper, we test whether this market exhibits predictability of prices in terms of momentum (i.e., positive/negative changes continuing) and overreaction (i.e., positive/negative changes reversing). We test whether momentum and overreaction exist in the carbon price, and if they do, whether they result in profitable trading strategies. We document a robust short-term momentum and medium-term overreaction within the EU ETS. We also find statistically significant returns in a number of strategies tested. The strategies employed provide excess returns that remain achievable in a practical sense even after transaction costs have been taken into consideration. Our results therefore provide evidence that the EU ETS is not informationally efficient.