Uncertainty in policy, uncertainty in markets: The dynamic relationship between economic policy uncertainty and carbon prices in China

Abstract

Stable and credible carbon price signals are essential for emissions abatement, efficient resource allocation, and low‐carbon investment. However, carbon markets remain highly dependent on policy design and implementation, meaning that greater uncertainty in economic policy could disrupt firms' production, compliance, and allowance‐holding decisions. Understanding how uncertainty is transmitted into carbon prices is therefore important for improving the effectiveness and resilience of emerging emissions trading systems. This study examines whether and how economic policy uncertainty affects carbon prices in China, how these effects evolve over time and differ across pilot markets, and through which economic and institutional channels they operate. Using monthly data from China's eight regional pilot carbon markets between January 2015 and December 2025, this study constructs a trading‐volume‐weighted composite carbon price index. It estimates a stochastic volatility time‐varying parameter factor‐augmented vector autoregressive model incorporating 55 macroeconomic, financial, energy and environmental indicators, and conducts robustness and mechanism tests. Economic policy uncertainty is incorporated rapidly into carbon price formation, with the strongest responses concentrated in the first four months and gradually converging thereafter. Composite carbon prices respond positively in most periods, although some episodes exhibit an initial decline followed by recovery. The direction, magnitude, and persistence of the responses vary substantially across markets. Macroeconomic conditions, energy prices, and institutional constraints amplify these effects by altering allowance demand, tradable supply, abatement costs, and compliance expectations. Carbon‐market governance should enhance policy stability, transparency, and advance communication; strengthen market depth, information disclosure, and price discovery in accordance with regional conditions; and improve coordination among macroeconomic, energy, and environmental policies. These measures would help reduce abrupt price adjustments and strengthen market resilience to uncertainty shocks.