Abstract:
This study examines the risk spillovers between energy futures prices and Europe-based carbon
futures contracts. We use a Markov regime-switching dynamic correlation, generalized
autoregressive conditional heteroscedasticity (MS-DCC-GARCH) model in order to capture the
time variations and structural breaks in the spillovers. We further evaluate the optimal weights,
hedging effectiveness, and dynamic hedging strategies for the MS-DCC-GARCH model based on
both the regime dependent and regime independent optimal hedge ratios. We finally complement
our analysis by examining the in- and out-of sample hedging performances for alternative
strategies. Our results mainly show significant volatility and time-varying risk transmission from
energy markets to carbon market. We also find that spot and futures segments of the emission
markets exhibit time-varying correlations and volatile hedging effectiveness. The subsample
estimates show significant changes in the hedge effectiveness over the different phases of the
European carbon market. These results have important investment and policy implications.