Volatility spillover effect and dynamic correlation between China's energy market and carbon market

Abstract

Fossil energy plays a crucial role in industrial systems and causes considerable carbon emissions. The fluctuations in energy markets and carbon markets are plausibly intertwined. Given the plausibly increasing linkage between the two markets, it is desirable to identify and quantify the volatility spillover effect and dynamic correlation between them, which is important for portfolio construction and policy making. This raises particular interest for China, the top carbon emitting country. This study investigates the volatility spillover effect and dynamic correlation between China's energy markets (crude oil and LNG) and the pilot carbon markets in Beijing, Shanghai, Hubei, and Guangdong. By using the VAR-BEKK and ARMA-EGARCH-DCC models, the study finds that only the Shanghai and Beijing carbon markets have unidirectional volatility spillover effects on the energy markets. This suggests that the volatility spillover effect between energy markets and carbon markets heavily depends on the financial literacy of investors. In addition, the dynamic correlations between energy markets and each pilot carbon market are heterogeneous. Particularly, the correlation between the Beijing carbon market and the LNG market is stable with no evidence supporting a dynamic trend, while short-run persistence dominates between the Hubei carbon market and the LNG market. These results can help policy makers better develop policies for China's national carbon market and assist investors in hedging risks in portfolio construction.