Market efficiency and the U.S. market for sulfur dioxide allowances

Focusing on the U.S. sulfur dioxide (SO2) allowance market from its inception in 1994 to 2009, we model allowance prices to determine the influence of market fundamentals on allowance price level and volatility. We find evidence that the SO2 market operates in ways that are not inconsistent with an efficient market – prices that reflect marginal abatement costs – after the first few years of the program but before a court decision that introduced significant uncertainty into the market in mid-2008. Our empirical analysis finds that the SO2 market, similar to other emission markets studied in the literature, can remain relatively inefficient for several years after launch. We also find that market volatility increases in response to all types of communications from the administrator, suggesting that the development of a formal communication strategy, possibly similar to that used by central banks, would reduce price volatility and increase the efficiency of the market.