Evolution and management of price risk in the carbon market: The role of hedging

Abstract This paper is motivated by the observed discrepancy between rising price volatility and declining hedging demand in the European Union Emission Trading System (EU ETS). To investigate whether the effectiveness of carbon futures as hedging instruments persists under varying scenarios, this paper evaluates the evolving price risk in the EU carbon market and examines the role of hedging in managing the risk. It investigates tail risk (corresponding to adverse market shocks occurring under rare events) and its temporal evolution over successive phases of EU carbon policy. Price risk is assessed empirically based on a quantile vector autoregression model of marginal price distributions along with a copula evaluation of the joint distribution of futures price and spot price. Applied to EU Allowance market over the period of 2008–2023, we find that: (1) the price distributions of both spot and futures market exhibit heavy‐tailed and leptokurtosis properties, thereby highlighting the significance of tail risk under changing policy schemes, such as the four phases of the EU ETS and shifting emission and energy policies; (2) decomposing the cost of risk across quantiles, we show that the risk located at the lower tail of the price distributions plays a dominant role; (3) we propose a novel Minimum Cost‐of‐Risk method based on the quantile vector autoregression, which more effectively evaluates the overall hedging performance in terms of cost of risk reduction compared to the traditional Minimum−Variance method.