The dynamic volatility spillover between European carbon trading market and fossil energy market

Abstract

With the rapid spread of carbon trading in the world, the interaction of carbon prices and fossil energy prices has raised growing attention, but little research has discussed their time-varying correlation and dynamic volatility spillover. This paper employs the threshold dynamic conditional correlation (DCC) generalized autoregressive conditional heteroscedasticity (GARCH) model and the full Baba, Engle, Kraft and Kroner (BEKK) GARCH model to explore these issues, for the daily data of European carbon futures prices and the three fossil energy prices (coal, natural gas and Brent oil) from January 2 2008 to September 30 2014. The results indicate that, first, there is significant unidirectional volatility spillover from coal market to carbon market and from carbon market to natural gas market, whereas there exists no significant volatility spillover between carbon market and Brent oil market. Second, carbon market and fossil energy markets have significantly positive correlation across time. Specifically, among the three fossil fuels, coal market has the highest correlation with carbon market, followed by natural gas and Brent oil markets. Finally, as for the three fossil fuels, their price decrease may have stronger impact on carbon price volatility than their price increase with the same degree, while there is asymmetric impact of carbon price increase and decrease only on Brent oil price volatility. These results may help investors to well configure their portfolios and manage their investment risks, and help emission trading installations to join in carbon market in a cost-effective way.