Today I received approval for the MSt Degree from Cambridge Institute for Sustainability Leadership (CISL) along with a distinguished dissertation titled "Enhancing the European Union Emission Trading System to Accelerate Decarbonization and the Energy Transition - An Analysis of the Impact of Integrating European Union Emission Allowances (EUAs) into Institutional Portfolios". I plan to publish the detailed results in a journal next year. I want to extend a special thanks to my dissertation supervisor, Emre Usenmez, and to the entire CISL team for their invaluable guidance and support.
The study explored the role of institutional investors in carbon markets, specifically in enhancing the EU ETS to accelerate decarbonization and the energy transition. It then conducted a two-part quantitative analysis to assess the potential benefits of diversification in institutional portfolios through the integration of EUAs.
Below is a short summary of some of the main results of the study:
The first part adapted a model of return and volatility connectedness analysis based on Diebold et al. (2012 & 2014) and Gabauer (2021). This analysis was conducted during Phases III and IV of the EU ETS (2013-2022) to capture the recent phases of the EU ETS, while also analyzing financial stress moments in 2018, COVID-19, and the Russian-Ukrainian War.
The return and volatility connectedness suggests that although the increase in the connectedness of EUAs with other financial markets—particularly during periods of financial stress—EUAs remain largely independent from these markets, with the exception of natural gas and coal, reflecting the inherent links that exist between energy and environmental markets, and EUAs return and volatility behaviour are still primarily driven by their own fundamental factors.
The second part made a backtest of portfolios that included EUAs, using two different optimization methods (MVO and Omega), and was compared with a portfolio that attempts to replicate the asset allocation of a European Pension Fund and has no allocation to EUAs. The integration of EUAs, regardless of the method employed, demonstrated improvements in various performance metrics.
Firstly, portfolios that incorporate EUAs into their allocations have higher returns compared to a portfolio without it. Secondly, these portfolios show improvement in risk-adjusted metrics, with higher Sharpe and Sortino ratios. Thirdly, the maximum drawdown (MDD), is slightly improved in the portfolios that include EUAs, and the two portfolios including EUA consistently outperform the Europe Institutional (no Carbon) portfolio almost every year.
The results of this study present a persuasive case highlighting that the inclusion of EUAs can be beneficial from a financial perspective, in line with institutional investors' fiduciary duties, while also enhancing the EU-ETS by fostering a more efficient, liquid, and transparent market.
#carbonmarket #sustainablefinance #cambridge #EUETS
