Empirical Evidence on Time-Varying Hedging Effectiveness of Emissions Allowances under Departures from the Cost-of-Carry Theory

Under departures from the cost-of-carry theory, traded spot prices and conditional volatility disturbed from futures market have significant impacts on futures price of emissions allowances, and then we propose time-varying hedge ratios and hedging effectiveness estimation using ECM-GARCH model. Our empirical results show that conditional variance, conditional covariance, and their correlation between between spot and futures prices exhibit time-varying trends. Conditional volatility of spot prices, conditional volatility disturbed from futures market, and conditional correlation of market noises implied from spot and futures markets have significant effects on time-varying hedge ratios and hedging effectiveness. In the immature emissions allowances market, market participants optimize portfolio sizes between spot and futures assets using historical market information and then achieve higher risk reduction of assets portfolio revenues; accordingly, we can obtain better hedging effectiveness through time-varying hedge ratios with departures from the cost-of-carry theory. 1. Introduction Greenhouse gas (GHG) emission is an ever-increasingly hot topic in the 21st century for alarming phenomena of global warming and extreme climate deterioration. Most of the scientists and politicians believe that emissions trading scheme is a cost-effective market scheme in order to control GHG emissions. Since the launch of the European Union emissions trading scheme (EU ETS) in 2005, CO2 emissions allowances have become valuable commodities which can be traded in CO2 emissions allowances markets. Spot, futures, options, and other financial products of emissions allowances are important financial tools for market participants to increase assets portfolio revenues and achieve higher risk reduction. In recent years emissions allowances markets have become the most promising and are quickly growing markets in global commodities markets. Spot and futures prices of emissions allowances depend on expected market scarcity induced by demand and supply quantity in the emissions allowances market. An early study of emissions allowances by Benz and Truck [1, 2] found that a good many complex factors such as GHS emissions reduction plan and regulation policy, low-technology promotion and application, energy prices volatility, and energy efficiency and extreme temperature changes have significant impacts on market scarcity. Seifert et al. [3], Daskalakis et al. [4], and Conrad et al. [5] asserted that spot and futures prices of emissions allowances have higher time-varying trends,