Intensity and Direction of Volatility Spillover Effect in Carbon–Energy Markets: A Regime-Switching Approach

Abstract

This paper advances a volatility-regime-switching mechanism to investigate the intensity and direction of the volatility spillover effect in carbon–energy markets. Switching between a low-volatility (LV) and high-volatility (HV) regime, our mechanism involves a four-state system (i.e., LV-LV, HV-LV, LV-HV and HV-HV). Our findings are listed as follows: First, the highest EUA–WTI correlation occurs when both are in an HV regime (i.e., HV-HV), revealing the intensity of the volatility spillover effect. Second, when EUA and WTI are experiencing an opposite volatility regime (one in LV and the other in HV), a higher EUA–WTI correlation is observed when WTI is in an HV regime. This result implies that the direction of the volatility spillover effect is from the energy market to the carbon market. Third, the regime-switching model involving the non-uniform volatility–correlation relations outperforms the conventional GARCH and DCC models in volatility forecasting and portfolio construction.