Time-frequency connectedness and spillover among carbon, climate, and energy futures: Determinants and portfolio risk management implications

Abstract

This study examines returns and volatility connectedness and spillover among carbon, climate, and energy futures using TPV-VAR frequency connectedness approach with daily frequency observations from December 15, 2020 to September 23, 2022. The study also evaluates factors that contribute to connectedness and explores hedging benefits from using carbon and climate futures with bivariate and multivariate portfolio strategies. This study reveals higher levels of total return and volatility connectedness and spillover effects across carbon, climate, and energy futures markets. There are persistent high spillovers in the short term, but spillovers are lower in the long run. These spillover effects are time-varying and change with economic, geopolitical, financial market events. For return and volatility spillover, carbon, climate, natural gas, gasoil and coal futures serve as net informational and risk recipients while Brent crude oil, heating oil and gasoline futures serve as informational and risk transmitters. This transmission mechanism remains consistent in the short term. However, in the long term, crude oil futures became a net receiver, while climate change futures changed to a risk transmitter. The findings indicate that transmission mechanism changed during the Russia-Ukraine war, whereby carbon, Brent crude oil, heating oil, gasoline and gas oil futures played different roles in the return and volatility spillover network. We find that geopolitical risk, equity market volatility, global financial stress, and clean energy innovations are determinants of return and volatility connectedness. Understanding the interrelations among carbon, climate and energy markets can guide policy making to improve the effectiveness of climate actions. The findings also underline the hedging and portfolio diversification implications of carbon and climate futures for energy commodities market.