Inefficiencies of Carbon Trading Markets

The European Union Emission Trading System is a prominent market-based mechanism to reduce emissions. While the theory of cap-and-trade systems is well-understood, we provide the first comprehensive analysis of the EU-ETS as a financial market across its entire history, from its inception in 2005 through the current Phase IV. Analyzing the universe of transactions in 2005-2021 (more than one million records of granular transaction data), we show that this market features significant inefficiencies undermining its goals. First, about 40% of operators — that is, non-financial firms subject to compliance obligations — never trade in a given year, though this share declines to 20% by early Phase IV. Second, many operators only trade during surrendering months, when compliance is immediate and prices are predictably high. Third, a number of operators engage in speculative trading, exploiting private information.