Climate change and fossil fuel prices: A GARCH-MIDAS analysis

Abstract

In this study, we investigate the connection between climate change and the volatility of fossil fuel prices using the GARCH-MIDAS framework which accommodates mixed data frequencies and by extension circumvents information loss due to splicing or aggregation of one variable for the other. We conduct a battery of robustness tests that allow for nominal and real prices of fossil fuels as well as global financial crises (GFC). We show a strong connection between climate change and the volatility of fossil fuel prices albeit with stronger evidence in the post-GFC period. The outcome is positive in the recent period and therefore climate change seems to have heightened the volatility in the fossil fuel market. Even when the real prices are considered, results remain consistent, indicating that inflationary pressures do not diminish the effect of climate change on fossil fuel price volatility. We also show that own market risk positively impacts the volatility of fossil fuel prices and the volatility tends to persist when there is a shock to the fossil fuel market. More conscious efforts are needed to effectively discourage increased investments in environmentally-degrading assets.