Who gains from market fragmentation? Evidence from the early stages of the EU carbon market

We document the impact of market fragmentation during the first phase of the EU emissions trading scheme on the terms that traders were able to get. We observe the universe of over-the-counter (OTC) and exchange transactions and the transaction prices associated with four of the 11 exchanges that were active during that period. We define a measure of price advantage based on the difference between the transaction price and the median market-wide price that day. We decompose price advantage into its exchange, counterparty and trader drivers and show that where traders traded and how connected they and their counterparties were with the rest of the market covary with the terms they were able to obtain. Such features are expected to characterize OTC transactions but not, typically, anonymous exchange transactions. The high level of market fragmentation during the first phase, which was a policy choice, hampered information aggregation about the overall balance between supply and demand in the market, and put small and non-energy compliance traders at a large disadvantage.