Options introduction and volatility in the EU ETS

• Published in: Resource and energy economics 2011-11, Vol.33 (4), p.855-880
• Main Authors: Chevallier, Julien, Le Pen, Yannick, Sévi, Benoît
• Format: Article
• Language: English
• Subjects: Air pollution caused by fuel industries; Applied sciences; Climate; Commodities; Derivatives; Dynamics; Ecology, environment; Economic data; Economics; Economics and Finance; Electric energy; Emissions trading; Empirical analysis; Endogenous structural break detection; Energy; Energy economics; Energy. Thermal use of fuels; EU ETS; EU ETS Option prices Volatility GARCH Rolling estimation Endogenous structural break detection; Exact sciences and technology; Fossil fuels and derived products; GARCH; General, economic and professional studies; General. Regulations. Norms. Economy; Humanities and Social Sciences; Life Sciences; Markets; Methodology. Modelling; Option prices; Put & call options; Risk management; Rolling estimation; Stochastic models; Studies; Volatility
• ISSN: 0928-7655; 1873-0221
• DOI: 10.1016/j.reseneeco.2011.07.002

► The first study to assess the impact of derivatives introduction on the volatility of the underlying EU ETS futures contract. ► Results show a significant decrease in volatility after the introduction of options. ► Robustness checks about the methodology, the proxies or the relevant date for introduction confirm the empirical findings. To improve risk management in the European Union Emissions Trading Scheme (EU ETS), the European Climate Exchange (ECX) has introduced option instruments in October 2006. The central question we address is: can we identify a potential destabilizing effect of the introduction of options on the underlying market (EUA futures)? Indeed, the literature on commodities futures suggest that the introduction of derivatives may either decrease (due to more market depth) or increase (due to more speculation) volatility. As the identification of these effects ultimately remains an empirical question, we use daily data from April 2005 to April 2008 to document volatility behavior in the EU ETS. By instrumenting various GARCH models, endogenous break tests, and rolling window estimations, our results overall suggest that the introduction of the option market had the effect of decreasing the level of volatility in the EU ETS while impacting its dynamics. These findings are fairly robust to other likely influences linked to energy and commodity markets.