Liquidity and Market efficiency: European Evidence from the World’s Largest Carbon Market

Dr Gbenga Ibikunle, University of Edinburgh

We examine the efficiency of carbon financial instruments traded on the world’s largest carbon exchange, ICE’s ECX, by applying Chordia et al.’s (2008) conception of short-horizon return predictability as an inverse indicator of market efficiency. We find a strong relationship between liquidity and market efficiency such that when spreads narrow, return predictability diminishes. This is more pronounced for the highest trading carbon financial instruments and during periods of low liquidity. Since the start of trading in the Phase II of the EU Emissions Trading Scheme (EU-ETS) prices have continuously moved nearer to unity with, efficient, random walk benchmarks, and this improves from year to year. Overall, our findings suggest trading quality in the EU-ETS has improved markedly and matures over the 2008-2011 compliance years.

The findings in this paper hold significant implications for several stakeholders (aside from academics and students), including investors and policy makers (mainly departments responsible for the environment, energy policy, fiscal policy, trade policy and competitiveness) around the world. The findings also have implications for firms affected by EU-ETS legislations. For example, compliance traders will benefit from a stronger understanding of the market dynamics. For investors and compliance traders, this study will provide important insights that can be employed in formulating carbon investment strategies and effective risk management. This is vital when one considers that a market’s informational efficiency is a key requirement for investor participation in that market. A market with a high level of price discovery efficiency is important for efficient allocation of scarce resources.

Reference

Chordia, T., Roll, R. & Subrahmanyam, A. (2008) Liquidity and market efficiency. Journal of Financial Economics, 87(2), 249-268.

JEL Classifications: G12, G13, G14, G15, G18

Keywords: Liquidity; Order flow ; Market efficiency ; Return predictability ; European Climate Exchange; EU Emissions Trading Scheme (EU-ETS); Carbon futures