Modeling EU allowances and oil market interdependence. Implications for portfolio management

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.

► Dependence between EU allowances and oil markets is examined. ► We found positive average dependence and extreme symmetric independence. ► The implications of dependence for portfolio management are examined. ► Portfolio diversification benefits, hedging effectiveness and VaR reduction are found. ► The EUA market is an attractive market for investors.