Volatility spillover and hedging strategies between the European carbon emissions and energy markets

Abstract

Much attention has been paid to the complex risk transmission between carbon and energy markets along with the increasing global financial market integration. This research thus uses the DCC-MVGARCH model and spillover index method to investigate volatility linkages between the European carbon emissions and energy markets. The results make it clear that there are indeed volatility correlations and bidirectional spillover effects for the above two markets. In particular, the volatility correlations and the spillover index dramatically change when global economic turbulence and political events occur. Apart from the strongest volatility correlation between coal and carbon markets, the volatility spillover effect from the renewable energy market to the carbon market is gradually increasing. The role of the carbon market is also changing: the net information recipient becomes a transmitter from phase II to phase IV. Therefore, our findings provide investors with flexible portfolio strategies by making full use of dynamic volatility linkages between the two markets. This research also gives a decision-making basis for market regulators to improve the carbon market's risk management mechanism. It means that regulators should pay close attention to potential market risk sources. Further policy recommendations are put forward in the conclusion section.