Politics Matters: Regulatory Events as Catalysts for Price Formation Under Cap-and-Trade

Abstract

This paper investigates whether and how allowance prices respond to regulatory news in the world's largest cap-and-trade system - the EU ETS. Capitalizing on an event study method that incorporates an econometric technique designed to handle parameter instability and model uncertainty, we assess the news-implied price response to 29 hand-collected announcements about the EU ETS supply schedule between 2008 and 2014. Our findings document a high responsiveness of the cap-and-trade market to political events and reveal how market participants view the evolution of cap stringency in the light of a particular announcement. We provide strong evidence that backloading caused substantial price declines. The latter evolve gradually as market confidence in the political support for backloading and a stringent EU ETS is shaken in the lengthy legislative process. We also document positive price reactions to the 2020 and 2030 policy packages, but not the 2050 roadmaps.

Keywords: cap-and-trade, EU ETS, allowance supply, political uncertainty, event study, Bayesian

JEL Classification: C11, C53, G14, Q52, Q54, Q58