Carbon emissions have been linked by scientists to human activities and are generally accepted to be responsible for the alarming phenomena of global warming and climate change. As a response to the global climate and environmental risks linked to the human-related emissions of CO2 in the atmosphere and in order to reduce their overall level, the 1992-signed Kyoto protocol proposed for the first time the trading of emission allowances or permits in organized financial markets. More than a decade later, in 2005, the EU introduced the emission trading scheme (ETS), which is a cap-and-trade system. After the introduction of the EU-ETS, carbon emissions in Europe are capped, traded and priced, exhibiting unique trading patterns. According to this cap-and-trade system, EU allocates to each country (jurisdiction) a maximum limit on the total amount of emissions permitted to emit, which are divided into units of permitted pollution, the so-called emission unit allowance (EUA). EUA’s are allocated to firms and each unit represents the right to emit one tonne of CO2 per year. Firms are required to hold EUA’s (permits) equivalent to their emissions measured in tons of CO2 per year, else they pay a significant fine. In this way, EU-ETS provides financial incentives to motivate firms to reduce emissions by imposing a charge on emissions exceeding a cap (ceiling).

During the initial two phases of the scheme, over the period 2005–2012, EUA’s were granted to European firms free of charge; whereas in the third phase over the period 2013–2019 the majority of the EUA’s are sold in auctions. Entities that chose to pollutemore than the allowances they received had to purchase extra allowances in the open market from firms that used less allowances than they received. The EUA’s (permits) are traded on an exchange and in this way they establish a market price associated with one unit of pollution. This led to the emergence of EU-ETS, the largest carbon market globally which accounts for about half the CO2 emissions in all EU member states and more than 11,500 installations that together emit over 2 billion tonnes of CO2 annually (World Bank 2014). Emitting more than allowed and buying additional permits incurs cash expenses for the firms and increases their marginal production cost. In contrast, firms with lower emissions may need to buy less additional permits and in this way reduce their marginal production cost or sell in the exchange their unused given permits and benefit from additional revenues. In this way, the cost of CO2 emission allowances along with the price of oil are expected to affect directly or indirectly almost all industries and consumers. However, the relationship between oil price shocks and emissions price remains an open research question.

The economic intuition behind the idea that oil price shocks of different origin may affect in a different way the emissions price is explained below. For simplicity assume an oil price increase which results into higher marginal production cost for companies using oil as an input. If the observed oil price increase is due to an unexpected disruption in oil supply (shock) making extracting oil from earth more difficult, say because of a new regulation or geopolitical events, then it is expected that companies using oil as an input will face higher marginal production costs and at the same time will not face an increase in the demand for their products. The absence of an increase in the demand for their products may be attributed to the fact that the increase in oil price is merely due to the unexpected oil-supply shock (lower supply) and not due to a boost in the global economic activity. In this case, oil users are not expected to increase their level of production and subsequently their CO2 emissions; leading to no significant change in the price of emission allowance unit (EUA). At the same time, it is possible that the combination of increased oil prices and low demand may force oil users to use alternative (cheaper) fossil fuel and in this way emit higher CO2 emissions, thereby increasing the CO2 emission allowance price. In turn, if the oil’s price increase is due to an unexpected increase in global economic activity, then oil users again face higher marginal production costs as they need to acquire oil at a higher price, but at the same time they face higher demand for their production output, which in turn leads into increasing their production level and CO2 emissions; leading to an increase in emission allowance price. Finally, if the oil’s price increase is due to a shock in oil-specific precautionary demand the impact on emission allowance price is not straightforward. If oil users decide to buy and store oil fearing oil’s future price increases and at the same time decide to buy emission allowances fearing also their future price increases due to higher demand, the short-run effect on emission allowance price is expected to be positive. In contrast, if oil users decide to buy and store oil fearing oil’s future price increases, then this might not affect emissions allowance price significantly in the short-run, as this oil is stored and does not necessarily translate into oil users increasing their production output that would lead emission allowance price to increase – they merely store oil for future use and in this way hedge their production costs associated with the acquisition of oil.