Carbon emission trading and equity markets in China: How liquidity is impacting carbon returns?

This paper aims to investigate the impact of liquidity on the return dynamics between the carbon emission trading market and the stock market in China from 2013 to 2021. In the carbon emission trading market, we find that liquidity on any given day can significantly predict the cross-section returns the next day. Furthermore, we examine the spillover effect between the two markets and find the carbon market has a greater impact on the stock market. We also find evidence that stock market liquidity can significantly improve the liquidity of the carbon market. Finally, we observe that the volatility in the stock market not only deteriorates the liquidity of the stock market but also the carbon market, where the impact for the latter is from decreasing trading volume and increasing prices.