Price and market behavior in phase II of the EU ETS

Since 2005, the EU ETS has provided a market-based price signal for European carbon emissions. This article reviews the literature on the formation of carbon allowance prices during phase II of the EU ETS. A consensus has emerged in the literature that allowance prices are driven by fuel prices and other variables that affect the expected amount of abatement required to meet the EU ETS emissions cap. However, this relationship is not robust, most likely because the relevant abatement technologies change with the economic conditions in which they operate. There is evidence that models that explicitly account for uncertainty about the future demand and supply of allowances are better at explaining allowance price variation during certain periods. However, our understanding of the level of the allowance price remains poor. We cannot say with any degree of confidence whether the allowance price is “right,” in the sense that it reflects marginal abatement costs, or whether there is a price wedge caused by uncertainty, transaction costs, or price manipulation. Nevertheless, we find that the EU ETS market has matured in phase II compared with phase I and that banking of allowances has induced the market to incorporate the future scarcity of allowances and, as intended, to smooth the effect of temporary shocks. We argue that further research is needed in several key areas to increase our understanding of the emissions allowance market provided by the EU ETS.