Carbon credit futures as an emerging asset: Hedging, diversification and downside risks

Abstract

Even though carbon futures as a new asset have attracted the attention of scholars, there have been few attempts to investigate potential benefits of investing in carbon credits. In this study, we analyse the feasibility of hedging and diversifying stocks with carbon futures. We adopt the dynamic conditional correlation (DCC) models which allow us to compute time-varying optimal hedge ratios, optimal weights and portfolio returns. These hedging and portfolio metrics are then compared with those derived for commodity futures. Our main results suggest that including a small portion of carbon futures in a stock portfolio provides hedging benefits and reduces overall risk for a given level of expected return. The COVID-19 outbreak seems to have changed the hedging dynamics and the hedging capability of carbon futures is impaired during the pandemic. In terms of diversification benefits, our results show that adding carbon to a stock portfolio improves the risk-adjusted performance overall. We further examine economic benefits as a measure of hedging performance and find evidence of positive utility gains that are strongly dependent on investors' risk aversion. Comparing the performance of carbon futures with commodities, hedging effectiveness of carbon futures is not as high as that of precious metals and agriculture futures, however, carbon credits outperform energy futures in terms of hedging and diversification.