Diversification effects of China's carbon neutral bond on renewable energy stock markets: A minimum connectedness portfolio approach

Abstract

Socially responsible investment (SRI) is becoming increasingly popular in China, with the announcement of carbon dioxide peaking by 2030 and carbon neutrality by 2060 (30–60 targets). As a conventional underlying asset of SRI, renewable energy stocks are attractive, but with higher price volatility than many other traditional industrial stocks. This paper aims to investigate the interaction and diversification effects of China's Carbon Neutral Bond (CNB), a new SRI underlying asset just launched in 2021, on renewable energy stocks using a novel minimum connectedness portfolio approach recently proposed by Broadstock et al. (2020). The empirical results show that, first, China's CNB is weakly related to renewable energy stocks, whether in the time or frequency domain, and is the main recipient of the net linkage effect. Second, different renewable energy stocks benefit differently from the diversification effect of CNB. However, in extreme market conditions, the diversification effect of the CNB is reduced. Third, the newly developed minimum connectedness portfolio approach can outperform traditional minimum variance and correlation methods by achieving higher cumulative portfolio returns. Finally, the Sharpe ratios of renewable energy stock portfolios with CNB are significantly higher than those without it across different allocation methods. These findings have important implications for policy makers and SRI investors.