Can energy commodity futures add to the value of carbon assets?

This paper examines whether energy commodity futures are an attractive asset class for helping investors manage carbon risk. We use futures prices for EU allowances (EUAs) and four energy-related commodities (crude oil, coal, natural gas, and electricity) in Phase II and about half of Phase III of the European Union Emissions Trading Scheme. Both static and generalized autoregressive score dynamic copulas are used to model the dependence between the EUAs and the four energy commodity futures prices, with an emphasis on the performance of two different portfolio strategies (diversified portfolios and hedged portfolios) and the resulting effect on risk mitigation in the carbon market. Our empirical results show that despite the superiority of the hedged portfolios in increasing the risk-adjusted returns of carbon assets, the dynamic diversified portfolios are much preferred for reducing variance and the downside risks of carbon assets. Of the four energy commodity futures examined, coal (electricity) is found to be the most (least) attractive in terms of mitigating the carbon risk. These results are confirmed in both sub-sample and out-of-sample analyses.