TRANSACTION COSTS AND NONLINEAR MEAN REVERSION IN THE EU EMISSION TRADING SCHEME

Abstract

The potential benefits of tradable pollution permits and allowances can be limited by transaction costs. The implementation and operation of the European Union Emission Trading Scheme (EU ETS) involves transaction costs such as internal costs, capital costs, and consultancy and trading costs. This paper investigates the effect of transaction costs on market efficiency and price discovery in the EU ETS. An empirical assessment of nonlinear mean reversion is provided using threshold cointegration, which allows for asymmetric regime-dependent adjustment to the equilibrium relationship between European Union Emission Allowances (EUA) spot and futures prices. The mean reversion process reveals nonlinear and regime-dependent adjustment, and thus the empirical evidence indicates that transaction costs affect the mean reversion behavior and restrain market efficiency and price discovery.