Connectedness mechanisms in the “Carbon-Commodity-Finance” system: Investment and management policy implications for emerging economies

Abstract

Prior studies investigating the interactions between the carbon market with other markets are confined to developed countries, largely overlooking emerging economies that encounter environmental dilemmas caused by high carbon emission coupling with an economic boom. This study examines the connectedness mechanisms in the “Carbon-Commodity-Finance” system in emerging economies by applying a spillover index approach with the estimated vector autoregression model. Given the recent green development for tackling climate change, this study also looks into the role of green bonds and new energy index stocks in the system. Our results suggest that: (i) the pattern of system-wide spillovers changes over time and is notably driven by economic policy uncertainties; (ii) the stock market is the system's primary source of shock contagion, with green bonds being the largest shock receiver; (iii) the carbon market is heterogeneously connected with commodity and financial markets, receiving shocks from stock, silver and copper markets, and transmitting the shock to the gold market, while interacting across carbon markets directly or indirectly through energy markets, foreign exchange rates, and green bonds; and (iv) investment risk in most markets in the system can be greatly reduced by creating portfolios with other markets, except for green bonds, which are not ideal as hedging tools. These findings have significant implications for investors and policy makers in emerging economies to plan actions for asset allocation optimization and market risk management.