The European Union introduced the EU ETS, European Union Emissions Trading System, in 2005. ETS is a “cap and trade” system, where a cap is set for the total amount of emissions that can be produced by the entities covered by the system. The system aims to reduce the total amount of greenhouse gas emissions over time by encouraging entities to reduce their emissions through market-based mechanisms. The EU sets the quotas for total emissions rights.

Entities covered by the ETS are obligated to have an amount of emission rights that matches the emissions they produce as a by-product of their business. Entities that have a surplus of emissions rights can expand their output or sell the emission rights to other entities covered by the ETS. Entities that have a deficit of emissions rights must buy the rights from other participants at a market cost. Through this mechanism, ETS aims to reduce greenhouse gas emissions in a costoptimizing manner, directing the emission reductions to functions where the reductions are the most cost efficient.

This study aims to provide new evidence on the profitability of a trade strategy called carry trade in emission futures. In a carry trade strategy a speculator buys the contract of a shorter maturity and sells the contract of a longer maturity (or vice versa), aiming to return a profit from the trade as the prices of the two instruments converge. The strategy is based on the existence of inconvenience yield observed on the term structure. Convenience yield can be described as the utility of having a commodity “at hand”, ready to be used as a factor of production. Inconvenience yield can then be described as the inconvenience of having the product at hand.

Based on econometric regression it is concluded that spot price and spot volatility of emission allowances, German electricity price and its volatility are identified as statistically significant drivers or the inconvenience yield. The price of oil, macroeconomic drivers and changes in riskfree interest rates are not found statistically significant. Based on simulated trades, the negative carry trade strategy over one-year and two-year time periods has generated returns exceeding the risk-free interest rate with a low frequency of large drawdowns within the holding period.

The results indicate that the EU ETS is a very unique marketplace with the term structure of contracts being uncorrelated with the chosen broad macroeconomic variables. The marketplace doesn’t seem to fulfill the conditions of informational efficiency, as there still exists opportunities for significant arbitrage returns.