The European Carbon Emissions Trading Scheme introduced in 2005 has led to both spot and futures market trading of carbon emissions. However, despite seven years of trading, we have no knowledge on how profitable carbon emissions trading is. In this paper, we first test whether carbon forward returns predict carbon spot returns. We find strong evidence on both in-sample and out-of-sample predictability. Based on this evidence, we forecast carbon spot returns using both carbon forward returns and a constant. We consider a mean-variance investor and a CRRA investor, and show that they have higher utility and can make more statistically significant profits by following forecasts generated from the forward returns model than from a constant returns model.
- Emissions trading scheme