Disentangling Supply and Demand Shocks in the EU ETS – Before and After the Introduction of the Market Stability Reserve

This paper employs a Structural Vector Autoregressive (SVAR) model to analyze the impact of supply and demand shocks on European emission allowance (EUA) prices. We decompose EUA price changes into five components: (1) policy surprises, identified through a high-frequency approach, (2) demand shocks driven by economic activity, (3) shocks to the electricity sector's expected demand linked to fossil fuel price fluctuations, (4) shocks to the electricity sector's realized demand, measured using a novel metric based on electricity generation data, and (5) market-specific shocks, primarily reflecting precautionary demand driven by expectations of future policy tightening. Our results show that all these shocks significantly impact EUA prices. However, post-2019, the introduction of the Market Stability Reserve (MSR), which tackled excessive oversupply in the system, decreased the influence of policy interventions and precautionary shocks, aligning EUA prices more closely with the other demand-side factors. While only 33.5% of the variance in EUA prices can be attributed to the three real-time demand shocks before 2019, this figure almost doubled to 58.4% after the MSR's introduction. This shift suggests that a mechanism to address oversupply can be a crucial step towards achieving a more efficient, real-time demand-driven carbon pricing in emissions trading systems. • Fundamental shocks in the EU ETS are decomposed using a SVAR model. • Introduced new measures to proxy EUA market fundamentals. • Post-Market Stability Reserve (MSR), the contribution of demand shocks to EUA price variance increases to 58%. • MSR reduces speculative impact, fostering real-time demand-driven carbon pricing.