By Claudia Hitaj and Andrew Stocking
Focusing on the U.S. sulfur dioxide (SO2) allowance market from its inception (in 1994) to 2009, we model allowance prices to determine the influence of market fundamentals—such as prices of high- and low-sulfur coal—on allowance price level and volatility. Our empirical analysis finds that the SO2 market, similar to other emission markets studied in the literature, had relatively weak influence of market fundamentals for several years after launch—that is, allowance prices did not reflect marginal abatement costs for the first several years of operation. However, we find evidence of increased influence of market fundamentals after the first few years of the program but before a court decision that introduced significant uncertainty into the market in mid-2008. We also find that market volatility increased in response to all types of communications from the administrator, suggesting that the development of a formal communication strategy, possibly similar to the strategy used by central banks, would reduce price volatility and increase the efficiency of the market.