Understanding the Link Between Aggregated Industrial Production and the Carbon Price - Green Energy and Efficiency: An Economic Perspective - page 109

Durban COP/MOP meeting has given a temporary lifeline to the CDM, but not on
its longer term future (after 2015).
As a consequence, the uncertainty about the future of the markets, in combi-
nation with recurrent fears about

within the EU ETS as well as the
impact of the recession on emissions themselves, have kept carbon prices at rela-
tively low levels. Despite this absence of a binding international agreement, several
new or emerging systems and regional initiatives are underway that result in the
creation of new domestic markets (RGGI, California, Western Climate Initiative,
Australia, China, South Korea, REDD+ , etc.).
Against this institutional background, economic activity is perhaps the most
obvious and least understood driver of CO 2 price changes. Economic growth leads
to increased energy demand and higher industrial production in general. Despite
numerous contributions in the

“ over-allocation ”

eld of carbon price modeling (e.g., supply and
demand fundamentals, and expected future regulatory action), the last puzzle to be
solved in relation to the price drivers of European Union Allowances (EUAs) is
thus to determine the in uence of economic activity, through changes in CO 2

emissions levels.
This link between the carbon market and economic activity can be captured by
the interaction between the price of CO 2 and changes in the levels of industrial
production. Indeed, it is widely acknowledged in macroeconomics that changes in
the rate of utilization of industrial capacities provide an early warning of future
changes in the levels of GDP. Therefore, industrial production can be considered as
a good proxy for the evolution of the economic activity in the industrial sectors
regulated by the EU ETS.
This relationship may be understood intuitively: as industrial production increa-
ses, associated CO 2 emissions increase, and therefore more CO 2 allowances are
needed by operators to cover their emissions. This economic logic results in carbon
price increases ceteris paribus . More work is needed on this topic, especially to
understand the adjustment process of carbon prices to the macroeconomic environ-
ment, for instance by focusing on the underlying nonlinearities of the data. Since
2008, the deep recession arising from the

nancial crisis has spread to the sphere of
commodities (including CO 2 ), and it has very much depressed the carbon price
signal. As of today s state-of-the-art literature, there lacks a comprehensive study on

the adjustment of the price of carbon to the global economic recession that this
chapter aims to

'

ll.
The remainder of the chapter is organized as follows. Section 2 provides a
background discussion on the current status of the EU ETS. Section 3 explains the
main mechanism at stake concerning the link between the carbon price and the
macroeconomy, along with the

ndings from previous literature. Section 4 develops
the empirical analysis based on the class of threshold VAR models. Section 5
brie

y concludes.