Modeling the Dynamics of Implied Carbon Price and its Influence on the Stock Price Variability of Energy Companies in the Australian Electric Utility Sector

In July 2012, the Australian government introduced a Carbon Pricing Mechanism (CPM) to regulate national Greenhouse Gas (GHG) emissions. However, due to political controversies, there were concerns over the fate of this policy throughout its implementation. To determine the effect of carbon pricing policy on major electric utility companies, this chapter extracts an implied carbon price from the Australian electricity derivative market and models its volatility interaction with the utility index in Australian Stock Exchange (ASX).We find that Autoregressive Conditional Heteroscedasticity (ARCH) model can adequately simulate and forecast the dynamics of implied carbon price. As the cost of carbon emissions was fully transparent and passed onto the market, carbon pricing pushed up electricity prices, which subsequently enhanced expected stock returns of electric utility companies. While shocks from implied carbon price caused immediate response in the stock market, transfer of volatility from the latter to electricity derivative market was lagged. The persistent shift of volatility level further demonstrates the effect of carbon pricing and related policy uncertainty on the Australian electric utility sector. Findings from this chapter provide insight into market sentiment on carbon pricing policy and can contribute to financial risk management.