EU ETS Market Expectations and Rational Bubbles

This paper tests whether the sharp rise in EU Emissions Trading System (EU ETS) allowance prices from 2018 onward was driven by a rational bubble. The methodological contribution is to modify the Fama (1984) Predictive Regression (FPR) approach to remain valid for rational bubble testing when the risk premium is time-varying — potentially stationary, integrated of order one, or even explosive — and when the fundamental price process exhibits a unit root or mildly explosive behavior. Standard bubble tests (including the KPSS applied to the price-expectations differential, and the Phillips-Shi-Yu SADF/GSADF tests applied to price levels) lose size control when the risk premium follows a nonstationary process; the paper’s FPR approach combined with the IVX estimator of Kostakis, Magdalinos, and Stamatogiannis (2015) retains correct size under all risk premium specifications. Using weekly EU ETS spot and futures data from 2013 to 2023 (T = 563), the paper finds: (1) explosive behavior in both spot and futures price levels during the third and fourth trading phases (2018–2023), confirming a necessary condition for a bubble; (2) no evidence of a rational bubble in the FPR test — the IVX-AR Wald statistic fails to reject the null of no bubble (β₂,ₙ = 0) in full-sample and sub-sample analyses across delivery horizons of 4, 8, 12, and 16 weeks; (3) no evidence of explosiveness in the differential between future spot rates and futures rates; (4) no evidence of co-explosiveness between spot and futures prices within either the third or fourth trading period separately. The paper concludes that the EU ETS price surge reflects a shift in market expectations about future allowance scarcity — driven by policy tightening of the cap trajectory and reform of the Market Stability Reserve — rather than speculative excess.

Christoph Wegener | Macro Paper Warehouse

EU ETS Market Expectations and Rational Bubbles