The predictive role of implied volatility in European carbon market returns across investment horizons

Abstract

Prior studies have only taken into account the predictability of emerging economies’ carbon-trading markets by using spot-based commodity-market returns. This study theoretically advances the existing literature on energy economies by integrating different forward-looking uncertainty sources from the European equity (VSTOXX-50), forex (EVZ), oil (OVX), and gold (GVZ) markets to predict EU ETS returns. Therefore, this article enriches the discussion on carbon finance and EU ETS price formation by exploring how distinct European and global implied-volatility channels transmit enduring and transitory shocks to EU ETS across varying regimes, i.e., the pre-COVID-19, COVID-19, post-COVID-19, and overall sample periods. Overall, findings based on the autoregressive distributed lag model with automatic lag adjustment show that OVX and GVZ cause significant yet transitory adverse effects on EU ETS returns during the overall sample, pre-COVID-19, and COVID-19 periods. However, VSTOXX-50 causes a more persistent and significant adverse effect on EU ETS returns across all regimes, outweighing the influence of global commodity-market implied volatility. EVZ only decreases EU ETS returns during the COVID-19 regime. These results also contribute by providing practical implications that the implied-volatility indices of global commodity, European equity, and forex markets should be regarded as potential external sources of EU ETS return dynamics and must be incorporated into EU ETS forecasting frameworks for portfolio optimization. This article also contributes by identifying potential global and regional implied-volatility factors that can disrupt EU ETS price formation during periods of uncertainty, thereby aiding the development of portfolio diversification and hedging strategies across different regimes and investment horizons.