Financial stability and European union allowances: a tale of jumps and regime shifts

ABSTRACT

Using an event-study methodology, we investigate the impact of European Union Allowances (EUA) on measures of systemic risks for financial institutions. We analyse daily data on all banks listed on European exchanges. We find statistically significant abnormal changes in systemic risk measures around days when prices of allowances either jumped or shifted regimes. The paper also documents reduced systemic risk around positive jumps and regime shifts of allowances and increased systemic risk throughout negative jumps and regime shifts. Our contribution to the literature consists in producing evidence that financial stability supports the European carbon market initiative to mitigate climate change. These results have significant implications for policymakers and financial institutions.

KEYWORDS:

• Financial stability
• emission allowances
• event study
• daily jumps
• regime shifts

JEL CLASSIFICATION:

• G15
• G14
• Q53

Acknowledgements

The authors thank Taufiq Choudhry and Paul Turner for their comments on an earlier draft of this paper. We also thank two anonymous referees for the comments.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

¹ We elongated the sample data to January 2021 to account for possible aftermath effects in case extreme events (jumps) are detected at the end of 2020.

² We provide details of the methodology in Appendix 3.

³ We use the Facebook Prophet Library to estimate regime breaks. Appendix 4 contains the specific methodological information.

⁴ We experimented with different-sized windows, which did not significantly alter our results.

⁵ We accept Lee and Mykland’s (2008), recommendation that this window be sixteen days.