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This paper examines the dependence structure between European Union allowances (EUAs) and crude oil markets during the second commitment period of the European Union Emissions Trading Scheme and the implications for portfolio management. Using different copula models, our findings suggest positive average dependence and extreme symmetric independence that is consistent with interdependence and no contagion effects between the EUA and crude oil markets. The implication of this result for EUA-oil portfolios points to the existence of diversification benefits, hedging effectiveness, and value-at-risk reductions. The EUA market is therefore an attractive market for investors in terms of diversifying market risk and reducing downside risk in crude oil markets.

After implementation of the European Union (EU) Emissions Trading System (EU ETS) in January 2005, EU Allowances (EUAs) became a tradeable asset that could be negotiated in organized spot, futures and options markets. Under the new cap-and-trade paradigm, the EUA market has witnessed rapid development and is steadily increasing in size, complexity, liquidity and trading volume. This has greatly spurred research into allowance allocations and pricing mechanisms in the European carbon market, of primary interest to policy makers, traders and risk managers operating in this and related markets. One strand of the literature analyzes the price dynamics of different EU ETS instruments on a daily or intraday basis (Benz and Trück, 2009, Chevallier, 2009a, Conrad et al., 2012, Daskalakis et al., 2009 and Paolella and Taschini, 2008), price efficiency and information transmission between EU carbon spot and futures markets (Benz and Hengelbrock, 2008, Chevallier, 2010, Milunovich and Joyeux, 2010, Rittler, 2012 and Uhrig-Homburg and Wagner, 2009) and the impact of the EU ETS on the financial markets (Daskalakis and Markellos, 2009, Oberndorfer, 2009 and Veith et al., 2009). Another strand has explored the potential drivers of carbon price changes (Alberola et al., 2008, Bredin and Muckley, 2011, Christiansen et al., 2005, Convery and Redmond, 2007, Kanen, 2006, Mansanet-Bataller et al., 2007 and Redmond and Convery, 2006), finding that carbon prices are closely linked to exceptional weather conditions, economic growth and energy prices.1 Despite the fact that carbon prices were found to be closely associated with oil prices at the theoretical and empirical level (see Kanen, 2006 and Redmond and Convery, 2006) and that both EUAs and crude oil are negotiated in well-developed spot and futures markets, no study has yet examined the cross-market linkages between these two commodities. The main objective of our study, therefore, was to analyze the EUA and crude oil market dependence structure using copulas, a methodology that allows greater flexibility in modeling dependence than parametric bivariate distributions and, more interestingly, that enables us to determine whether EUA-oil markets are somewhat dependent or independent on average or in times of market stress on the basis of their tail dependence. Although oil and carbon prices are theoretically linked through the effects of oil price changes on natural gas and electricity price movements, how EUA prices react to extreme oil price market movements and vice versa is an empirical issue that needs to be addressed. In addition, understanding how EUA and crude oil markets co-move is essential information for optimal portfolio design and risk management decision making by investors and traders operating in those markets. We thus investigated the implications of EUA-oil market average and tail dependence for portfolio management by analyzing optimal portfolio weights and hedge ratios for EUA-oil portfolio holdings compared to simple oil stock portfolios. Likewise, we evaluated whether an investor could achieve downside risk gains from a portfolio composed of crude oil and by EUAs analyzing the value-at-risk (VaR) performance. Our empirical study was conducted from the onset of Phase II of the EU ETS in 2008, as it was in this phase that a more stable relationship was configured between the EUA system and its determinants (Bredin and Muckley, 2011) and market liquidity in EUA futures markets experienced a significant rise (Benz and Hengelbrock, 2009 and Bredin et al., 2009). By analyzing daily data for EUA futures contracts and crude oil prices, our study makes two major contributions to the empirical literature on modeling carbon emissions. Firstly, our paper is the first study we are aware of that investigates the interdependence of EUA and crude oil markets using copulas and that provides empirical evidence of positive average dependence and extreme symmetric market independence between EUA and crude oil prices, with the Gaussian copula as the best performing dependence model. This evidence is consistent with no contagion effects between EUA and crude oil markets. Secondly, we address the consequences of EUA and crude oil market links for portfolio management and provide evidence of the usefulness of EUA stocks in a crude oil portfolio, given that they increase the risk-adjusted portfolio returns, show evidence of hedging effectiveness in reducing portfolio risk and, finally, show a significant VaR reduction and better performance in terms of the investor's loss function with respect to a portfolio composed only of crude oil assets. On the basis of these results, the EUA market is an attractive financial market for investors wanting to avoid market risk in crude oil markets. The rest of the paper is laid out as follows: Section 2 provides a brief overview of the EU ETS. In Section 3, we outline the methodology we used to study EUA-oil interdependence. 4 and 5 present data and results, respectively, and 6 and 7 discuss the portfolio implications of our dependence results and provides our conclusions, respectively.

The EU ETS was formally introduced in January 2005 with a view to reducing European emissions of CO2 in a cost-effective way. A restricted number of annual EUAs are assigned to firms that allow them to emit a specified maximum amount of CO2. The firms can either use up their quota of EUAs (i.e., emit CO2) or abate emissions and sell the surplus EUAs in the market. Thus, EUAs became a tradeable asset that could be negotiated in organized or over-the-counter markets in which the market value to the CO2 externality is fixed. Since its inception, the European carbon market has rapidly expanded in terms of complexity, liquidity, trading volume and attractiveness for traders and risk managers. Although several articles have investigated price discovery, efficiency, price determinants and the links between financial and carbon markets, no study has examined the cross-market linkages between the European carbon and crude oil markets. We examined the dependence structure between EUA and crude oil markets during Phase II of the EU ETS and considered the implications for portfolio management. Using a number of copula specifications that capture dependence in different ways, we provided evidence of positive average dependence and extreme symmetric independence between EUA and crude oil prices, with the Gaussian copula as the best performing dependence model. This empirical evidence is consistent with interdependence and with no contagion effect between EUA and crude oil markets. Regarding the practical implications of EUA-crude oil interdependence for portfolio management, our results point to the usefulness of EUAs in reducing portfolio risk and improving portfolio performance, as risk-adjusted returns increased when EUAs were included in the crude oil portfolio. Our results also corroborated the hedging effectiveness of EUA futures. Finally, we showed that a portfolio composed of both EUA and crude oil stocks experienced significant VaR and ES reductions and yielded a better performance on the basis of a VaR investor's loss function. On the whole, EUAs can be rated as an asset that can improve the risk-adjusted performance of a portfolio that is well diversified so as to hedge crude oil risk and reduce downside risk.