A Pricing Analysis of European Cap & Trade Carbon Futures: Trading Strategies and Implications

Abstract

The global response to changing climate conditions has overwhelmingly been in favor of strong regulation: banning internal combustion engines, limiting use of certain fossil fuels, prohibiting gas stoves, and restricting single-use plastics. Indeed, many believe pure economic progress and capitalism to be generally incompatible with environmental protection. However, the European Union, in their implementation of their Emissions Trading System (EU ETS), has demonstrated that there is an alternative where economic progress is not only fundamentally compatible with, but necessarily commands environmental protection. In this cap & trade system, corporations in certain high-emission sectors are required by law to purchase rights to emit CO2 to offset their emissions or pay fines. That said, with carbon credit prices at all time highs, many are calling for reform. Principal amongst their arguments is the interference of financial speculators; Buyers or sellers who simply participate to derive financial gain and are not required to under the EU ETS system. These speculators are often blamed not only for placing excessive pressure on the market, but for inducing large volatility as well which, they claim, makes pricing nigh impossible for corporations who are unable to opt out of the system. As such, this paper seeks to evaluate the veracity of the claim that the European Union carbon credit prices are significantly driven by market speculation. To accomplish this goal, this thesis blends traditional financial modeling approaches such as Least Absolute Shrinkage and Selection Operator regression (LASSO) and the division of historical prices into market regimes with new approaches in Deep Learning, particularly Long Short-Term Memory networks. After showing that car- bon credit prices are in fact readily modeled with precision, this thesis concludes that carbon prices are indeed strongly correlated to a slew of world states (such as weather) as well as commodities (such as oil or coal). Consequently, this paper concludes that market speculation is not a significant factor in carbon credit prices, at least in comparison to the speculation of the underlying commodities. All the while, elevated carbon credit prices incentivizes more companies to mitigate their CO2 emissions. As such, perhaps financial speculation which drives up the prices could reasonably be seen as good? Moreover, should trading carbon credits be considered a fulfillment of Equity and Societal Governance (ESG) investing principles? Yet, is the very framework of carbon credits even sound, or should the individual be responsible for their own carbon emissions and not corporations? Therefore, for the sake of completeness, this thesis will also briefly consider the political and ethical ramifications of financial speculation and carbon credits.