The Connectedness of Energy (CO2) Allowances (EUA and

CER), Fuel Sources (Oil, Natural Gas, and Coal) and

Electricity
Anirudh Iyer(1502025), Ankit Jain(1502027), Lokesh Ahuja(1502098) and
Ravi Gupta(1502149)
"Why you are studying the connectedness Energy emissions, Energy
Commodities and Electricity Price Index" "Is the Energy emissions, Energy
Commodities and Electricity Price Index are connected, if yes, explain why?"

Abstract
This draft analyses the relationship between the returns for carbon emission
allowance, electricity and conventional energy sources price (coal, oil and natural
gas), converging on the impacts of emissions trading for European Union markets.
This work displays that the effect of carbon emission allowance depends on the
energy combination of the country under analysis but it is not the only factor. Less
carbon limitation takes place in the European Energy Exchange (EEX) and
innovations in carbon emission are not strongly reproduced in electricity prices.
Keywords: CO2 emission allowance trading, Dispersion, Volatility,
Directional Volatility, Connectedness, Directional Connectedness, Energy
mix impact
Introduction
The European Union Emission Trading System (EU ETS) was established on 1 st
January 2005 following the 2003/87/EC directive. It is one of worlds largest
emission trading schemes and a very integral part of the EU Climate policy created
along with Kyoto Protocol. Kyoto Protocol has set a target of cutting the 1990 CO2
emission levels by 8%. The EU ETS monitors emissions from the sectors that are
more energy intensive. Governments issue permits to large CO2 emitting
installations and their equivalent is traded as options and futures.
The energy sector remains to be one of the primary contributors to greenhouse
gases, global warming, climate change and other emission related phenomena. In
the recent times, air pollution and climate change has become a major concern
especially in the urban areas. Emissions trading has been introduced to address this
issue where parties are allowed to buy or sell emission permits and credits for
emission reduction of some specific pollutants. Different countries use different
sources for energy generation which include nuclear, coal and other renewable
sources. The primary means of generation for any country depends on its
geographical characteristics as a result of which energy policies in different
countries are different. These policies along with certain other climate factors and
conventional sources of energy costs decide the electricity prices.
Weather, fuel availability and costs along with economic development determine
the CO2 productions. Carbon allowances are currently traded in electricity
exchanges all across Europe and their price depends on Demand- Supply dynamics.
Certified Emission Reductions (CERs) are a type of emissions unit (or carbon credits)
allotted by the Clean Development Mechanism (CDM) Executive Board for carbon
emission reductions achieved by CDM projects and verified by a DOE (Designated
Operational Entity) under the rules of the Kyoto Protocol. CERs can be purchased
from the primary market (bought from an original party that makes the reduction)
or secondary market (resold from a marketplace). At present, most of the permitted
CERs are documented in CDM Registry accounts only. It is only when the CER is
actually sitting in an operator's trading account that its worth can be monetized
through being traded.
EU Allowance (EUA) is the official title of the carbon credits or pollution permits
traded in the EU Emissions Trading Scheme (ETS). Each EUA characterizes one ton
of CO2 that the holder is allowed to emit. Allowance units are freely assigned or
auctioned to members of the EU ETS and can then be sold or purchased through the
carbon market. Firms within the scheme must surrender EUAs equivalent to their
emissions at the end of each compliance period. Those businesses that emit more
carbon than their cap have to purchase extra EUAs, while those that manage to
reduce their carbon emissions below their cap are entitled to sell their excess EUAs.
Greenhouse gas guidelines is expected to improve price competitiveness of the
currently expensive carbon efficient technologies & surge the costs of burning
conventional sources of energy. The measure is expected to slow down the pace of
climate change. Although the impact of such rule on secondary carbon intensive
goods and services is relatively well understood, the influence on the prices of
primary conventional sources of energy, like natural gas and coal is less clear. Yet
this issue is particularly significant for conventional sources of energy exporting
countries such as Australia, Canada, Russia, Middle East & for the rest of the world
that relies on carbon inefficient energy generation. A carbon liability is created upon
the release of CO2 into the atmosphere, and is not charged on the carbon content of
conventional sources of energy that can be possibly released through the process of
burning.
In the short to medium term, substitution effects are anticipated to play a major role
in determining the effect of greenhouse gases (GHG) regulation upon the prices of
primary fuel sources. For example, natural gas will in many cases replace coal as a
fuel source that generates lower carbon emissions. However, a complicating factor
is that carbon charges also apply to Greenhouse gases emissions created in the
process of mining conventional sources of energy from the ground, and that certain
types of fuel are mined in countries that have carbon regulation in place, while
others originate in regions exempted from carbon controls. This is likely to distort
substitution effects, making them contingent upon the geographic origin of
substitute fuels, as well as on the logistic cost. In the long-run, carbon efficient
renewable power sources, such as wind and solar electricity, are expected to
become more cost-effective and widely used. Although this will reduce the demand
for conventional sources of energy, it may also increase their attractiveness through
lower prices, resulting from decreased demand, and spare capacity.
In this paper we try to establish the connectedness between Energy (CO2)
Allowances, Fuel Sources (Oil, Natural Gas, and Coal) and Electricity. We take both
EUA and CER prices to represent energy allowance prices in the market while fuel
and electricity prices are picked up straight from the energy indexes.
In Europe, there are more than twenty different energy exchanges. The most liquid
exchanges are the European Energy Exchange (EEX) in Leipzig and the Nord Pool
Spot / Nasdaq Omx Commodities in Oslo. The main markets within an energy
exchange are the spot market, for short-term trading, and the forward market,
where the physical delivery of, for example, electricity or gas takes place at a future
date.
We propose to run analyses of electricity prices, fuel prices and carbon interactions
in at least five ways: (1) our period of analysis is from 2008 to 2016 ; (2) we extend
previous works to the German and French markets. These countries were selected
for the following reasons: the German electricity market is one of the biggest by
number of participants and generation capacity, and has strong connections with
the rest of the European countries (Madaleno and Pinho 2011a, b); allowances have
been traded since 2005 in both the markets; the German market is completely open
to competition, while the French market is still characterised by monopolistic
behaviours; both appear to behave coherently (Silva and Soares 2008; Pinho and
Madaleno 2011b); although France and Germany are already geographically close to
each other, they formed a regional market in January 2010; (3) We include other
fuel prices such as oil due to the energy mix that distinguishes the markets under
analysis, and we provide a VECM model with five endogenous variables; (4) we give
a clear answer on how the EU ETS has affected the electricity generation sector by
addressing countries heterogeneity (for both short and medium term interactions);
(5) finally, we include temperature dummies.
Empirical findings show that in the period under analysis, the European emission
allowances market failed to compel electricity producers to reduce their emissions
186 M. Madaleno et al. and invest in cleaner technologies whose efficiency depends
on the energy mix of the country under analysis. Policies related to the coal industry
have therefore a marginal influence on electricity prices.
This Paper intends to take the studies further and tries to establish the
connectedness of EUA, CER with fuel and electricity prices. We use the
connectedness measures proposed by Diebold and Yilmaz (2014) which allow us to
sidestep the contentious issues associated with the definition and existence of
episodes of fundamentals-based or pure contagion. Diebold and Yilmazs (2014)
methodology can be considered as a bridge between the two visions since
uncertainty is based on how much of the forecasting error variance cannot be
explained by shocks in the variable and volatility spill overs are examined using
useful information on agents expectations (which gauge the evolution of both
fundamental and market sentiment variables). Thirdly, as volatility tracks investors
perceived risk and is a crisis-sensitive variable which can induce volatility surprise
(see Engle, 1993), by measuring and analysing the dynamic connectedness in
volatility we will be able to examine the fear of connectedness expressed by
market participants as they trade. To sum up, in this paper we explore a new
challenging avenue of research, focusing our study on the analysis of
connectedness in World Energy markets volatility using Diebold and Yilmazs (2014)
methodology in order to fill the existing gap in the literature.
Literature Review
The issue of interdependence between carbon and conventional sources of energy
prices is examined in several papers. For example Bunn and Fezzi (2007) conduct
an empirical study of relationships between carbon permit prices and energy
sources. They find a statistically substantial relationship between the prices of
carbon allowances, conventional sources and electricity. Zachmann and von
Hirschhausen (2007) extend these findings by estimating asymmetric effects of
carbon allowance pricing on electricity prices in Germany, while Fell (2008) and
Chemarin, Heinen and Strobl (2008) also examined relationships between electricity
and carbon prices across several Nordic countries and France respectively.
Chemarin et al. find no short-run links between electricity and carbon, and conclude
that these two markets are not integrated. On the other hand, Fell (2008) the
carbon prices affect the price of electricity in the short-run and Alberola et al. (2008)
find that natural gas, electricity, and coal have a statistically significant concurrent
impact on the European CO2 allowances. Fell (2008) also finds a small optimistic
effect running from the price of carbon to the price of Nordic fossil fuel. A report by
the Nordic Council of Ministers (2008) finds carbon to be highly correlated with oil,
and less correlated with natural gas and coal, however do not conduct statistical
tests of these findings. Thus, the current literature provides some conflicting and
inconclusive evidence, and it appears that there is scope for more studies on the
topic.
The EU ETS is developed as the first large scale carbon dioxide ( CO2) emission
trading system in the world. It consists of three phases:
1. Phase 1 is pilot phase which ran from 205 to 2007.
2. Phase 2 ran from 2008 to 2012 and
3. Phase 3 of the system ran from 2013 till 2020.
The EU ETS will expire in 2020, if there is no consensus reached in internal climate.
If any company wishes to participate in the emission allowances market, it has to
open an account in the registry of its origin country as per the allocated stipulations.
The EU ETS spreads across 12,000 industrial installations and covers around 25 plus
countries; Every country involved has to propose its national allocation plan (NAP)
including the caps on greenhouse gas emissions for power plants and other sources.
The national allocation plan (NAP) must be approved by the European Commission.
Total quantity of carbon dioxide (CO2) allowances granted per year for each
company and for committed period is determined by National allocation plan.
The objective of the EU ETS is primarily to reduce emissions by promoting low
carbon technologies and efficient use of energy among CO 2 emitting plants and to
create a market price for allowances. European polluters will therefore be aware of
the environmental consequences of their polluting activities. As such, installations
need to surrender as many allowances during this period as the amount of carbon
dioxide emitted during the reference year.
Alberola et al. 2008 paper talks about the compliance requirement in EU ETS. As per
the paper, The EU ETS is a cap-and-trade scheme. There is an upper cap limit on the
overall level of emissions and any installation which fall short of allowances with
respect to its allocation level may purchase allowances in the spot market so as to
meet its regulatory requirements. Installations that are not able to meet their target
in Phase II have to pay a penalty of 100 /ton of CO2, as compared to penalty of 40
/ton in Phase I.
In the Ellerman et al. 2010 paper, At the beginning of Phase I, Initial amount of
permits were allocated to all the major emitters and they were allowed to trade
them on the open market. Every year, a similar new supply was given to same
sources, though the initial environmental benefits were limited because of over
allocation concerns among member states.
Koenig et al. 2011 paper talks about modelling the correlation in carbon and
conventional energy markets. That paper discussed correlations between daily
returns of monthly-ahead baseload electricity, conventional sources input and
carbon emission allowance (EU-ETS) prices. The viewpoint of a power plant operator
is assumed, producing baseload electricity with conventional sources and carbon
allowances and selling output forward in the future market. Price correlation
between electricity, conventional sources and carbon emission allowances as well
as their dynamic pricing behaviour is critical for the degree to which cash flows from
plants are hedged. Switching between input fuels with different carbon intensities is
taken as the fundamental driver of this correlation. Using daily observations of
future prices, the results suggested that extreme climate, high commodity market
volatility have no effect on correlation. However, there is indication of noteworthy
price decoupling during phases of extreme relative carbon emission and fossil fuel
prices.
To Identify the carbon price patterns researchers studied the dynamics of price
information flow between the German electricity prices and gas, coal, oil and wind
power in Germany. The Creti2012 paper focussed on the carbon future price
determinants in Phase 2 by trying to find the relationship between energy prices
and economic indicators. Although weather variable were not included in the study
as it was assumed that according to the existing research, its impact on carbon
prices was only indirect and thus appear in form of sudden shocks.
Emission permits for carbon have an opportunity cost equal to their market price.
While talking about the cost of electricity, the cost of carbon would thus be an
addition and must be included in the costing. Although technology and other
efficient practices might affect the aggregate effect of the carbon price. In order to
give incentives for reducing emissions, trading allowances are given for emission of
CO2. The resulting market as an asset value of Billions of Euros annually.
CO2 Trading is different from the conventional commodity trading due to the
following reasons :-
1. People who emit more than the allocated levels can buy the allowances from
the Sellers who emit less than the allowed levels.
2. The Carbon Credit system exists which offers motivation to countries to keep
their emission levels below the allocated levels in the form of various
incentives
 3. As far as stocks are concerned, a firm can decide the number of shares to be
issued whereas in the CO2 trading system, the annual quota of emission
allowances is given and controlled by the EU-Directive.
4. The Prices of Allowances depend upon the supply and demand balance
whereas value of stocks are determined by the expected profits of the firm
that distributes shares.
5. The Emission trading market has only the government that acts as the lone
source of allowance and emission permits
6. Allowances have a limited validity.

Empirical Methodology
We utilize the directional connectedness measures that are introduced by Diebold
and Yilmaz (2012, 2014, 2015). The objective of this econometric method is to
compute various interesting measures from the transmissions of implied volatilities
in a system that contains
the energy market and the allowances included in the study. Assume that implied
volatility indices, IVi are modelled as a vector autoregressive process, VAR(p) that
can be written as
p

IVi = IVt-i + t (1)

i=1

where is a NN matrix of parameters to be estimated. Also assume that the

vector of error terms is independently and identically distributed with zero mean,
and covariance matrix. If the VAR system above is covariance stationary, then

there exists a moving average representation that is given by IVt = A t-i, where
i=0

the NN coefficient matrices Ai obey a recursion of the form Ai=1Ai1+2Ai2+

+pAip with A0 is the NN identity matrix and Ak=0 for k<0.

The moving average coefficients are important to understand the dynamics given
that the variance decompositions are computed as transformation of the
coefficients in the moving average representation above. The variance
decompositions (or impulse responses) allow us to split the H-step ahead of forecast
errors of each variable into parts that can be attributable to the various market
shocks. The aggregation of these decompositions will be subsequently used to
compute the directional connectedness of a particular market to any or to all of the
markets under study.
The variance decompositions computation is usually done using orthogonal VAR
shocks. The Cholesky identification scheme achieves orthogonality but the
computed variance decompositions will then be unstable and dependent on the
ordering of the markets. Thus, Cholesky decomposition is not suitable. A framework
that produces invariant decompositions is the generalized VAR that allows
correlated shocks and accounts for them appropriately. The framework has been
first proposed by Koop et al. (1996) and Pesaran and Shin (1998) and is called the
KPPS hereinafter. Following Diebold and Yilmaz, the KPPS H-step-ahead forecast
error variance decompositions ijg (H) for H=1,2, , is computed as

H 1
2
jj (e i A h e j)
'
1
g h=0
ij (H) = H 1 (2)
( e'i A h A 'h ei )
h=0

where is the variance matrix of the vector of errors , and jj is the standard
deviation of the error term of the jth market. Finally, ei is a selection vector with one
on the ith element, and zero otherwise. In order to get a unit sum of each row of the
variance decomposition, Diebold and Yilmaz normalize each entry of the matrix by
the row sum as

ijg ( H )
g N
ij (H) = (3)
gij (H )
j=1

Note the sum of decompositions across any particular market ij g (H) =1, and
j=1

across markets ijg ( H) =N. Therefore, ijg (H ) can be seen as a natural

j=1

measure of the pairwise directional

connectedness from market j to market i at horizon H. To make Eq. (4) more
intuitive, we use the notation Ci j(H) to represent this transmission. In the same
way, we also compute the pairwise directional connectedness in the opposite
direction as Cji(H). The two statistics allow us to compute the net pairwise
directional connectedness as
Cij= Ci j(H) - Ci j(H) (4)
These are interesting statistics that indicate which market is playing the dominant
role in the information transmissions between the two markets.
In our case, we are particularly interested in determining how all markets together
are contributing to a single market, so we aggregate partially. The total directional
connectedness from all markets to
market i, denoted by Ci(H), is computed as
N

ijg (H )
j =1
Ci(H) =
i j 100 (5)
N

ij
g
( H)
i , j=1
Using the same logic, we are also able to compute how a particular market i is
contributing to the shocks of all other markets by aggregating partially. The total
directional connectedness from market i to all markets, denoted by C i(H), is
computed as
N

jig (H )
j =1
Ci(H) =
j i 100 (6)
N

g
ji ( H)
i , j=1

This is also an informative connectedness measure. Together with the previous

statistics they may define the role of the market in the whole system of markets as
a net transmitter or receiver of shocks. In
particular, we are occasionally interested in computing the net total directional
connectedness which can be calculated as
Ci(H) = Ci(H) - Ci(H) (7)
The total aggregation of the variance decompositions across all markets measures
the system wide connectedness. The total connectedness in all markets is given by
N

ijg ( H ) N
j =1
i j
ijg (H )
j=1
C(H) = N = i j (8)
ij
g
( H) N
i , j=1

This represents only the ratio of the sum of all off diagonal elements in the variance
decomposition matrix of all markets to the sum of all elements (off diagonal and
own shocks). It also measures the total information flow among all markets under
consideration.
Preliminary statistics
This figure shows the time series plot of the implied volatility indices of allowance
returns over the sample period from 1st of April 2008 to 29th September 2016.
As evidenced by the data, mean returns for all electricity spot markets are positive.
The Jarque-Bera statistic indicates that the distribution of returns for all samples has
fat tails and sharper peaks (kurtosis) than the normal distribution (kurtosis being
higher for natural gas and carbon prices). Skewness, which measures the degree of
a distributions asymmetry, is also very different from zero, and is negative for
carbon, natural gas, oil and electricity returns.
Moreover, volatility is high for all markets and there are no significant differences
between the average wholesale electricity returns in the two markets. Wolak (1998)
finds that prices in markets dominated by fossil fuel or thermal technology tend to
be much more volatile than prices in markets dominated by hydroelectric capacity.
According to the standard deviation obtained, which we see as our volatility proxy,
EEX presents higher volatility of both electricity prices and allowances.
Volatility increases costs for emitters and they prefer stable and predictable carbon
prices. In the carbon markets, there are generally two types of risk that participants
may want to transfer: carbon price volatility and carbon default risk (the risk that
offset projects may not achieve some or all of their carbon reductions). Both types
of risk would be found in a system with a high proportion of offsets and volatile
carbon prices.
This figure shows the time series plot of the implied volatility indices of allowance
price over the sample period from 1st of April 2008 to 29th September 2016.
 BEGAS Index Europe BEELECT Index Europe BEUELEC Index EMEA BPRELEC Index Asia Pacif ic
15 15 15 4

10 10 2
10

5 5 0
5
0 0 -2
0
-5 -5 -4

-5
-10 -10 -6

-10 -15 -15 -8

08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16

BEUGAS Index EMEA BPRGAS Index Asia Pacif ic BUSELEC Index Americas BUSGAS Index Americas
20 8 15 15

15
10 10
4
10

5 5 5
0
0 0 0
-5
-4
-5 -5
-10

-15 -8 -10 -10

08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16

CAR1 Comdty CER ICE CL1 Comdty Crude Oil WTI NYM MO1 Comdty EUA ICE 1M HO1 Comdty Heating Oil
300 20 40 20

200 20
10 10

100 0
0 0
0 -20

-10 -10
-100 -40

-200 -20 -60 -20

08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16

NG1 Comdty Natural Gas Henery Hub XA1 Comdty Coal Rotterdam XB1 Comdty Gasoline
30 20 30

20 10 20

10 0 10

0 -10 0

-10 -20 -10

-20 -30 -20

08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16
 BEELECT Index Europe BEGAS Index Europe BEUELEC Index EMEA BEUGAS Index EMEA
400 1,000 240 240

350
200
800 200
300
160
250 600 160
120
200
400 120
80
150

100 200 40 80
08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16

BPRELEC Index Asia Pacif ic BPRGAS Index Asia Pacific BUSELEC Index Americas BUSGAS Index Americas
160 320 200 400

180 350
140 280

160 300
120 240
140 250
100 200
120 200

80 160
100 150

60 120 80 100
08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16

CAR1 Comdty CER ICE CL1 Comdty Crude Oil WTI NYM HO1 Comdty Heating Oil MO1 Comdty EUA ICE 1M
24 160 500 30

20 25
400
120
16 20
300
12 80 15
200
8 10
40
100
4 5

0 0 0 0
08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16

NG1 Comdty Natural Gas Henery Hub XA1 Comdty Coal Rotterdam XB1 Comdty Gasoline
16 800 400

350
12 600
300

250
8 400
200

150
4 200
100

0 0 50
08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16
Table 1- Descriptive statistics of the implied volatility indices for allowance
returns

Table 2- Correlation among the implied volatility indices for allowance

returns
Table 3- Descriptive statistics of the implied volatility indices for allowance
prices
Table 4- Correlation among the implied volatility indices for allowance
prices

Table 5- Full Sample directional of implied volatility connectedness

Empirical Results
Static volatility connectedness analysis
Table 5 reports the full sample cross market connectedness of the first difference of
implied volatilities. The diagonal elements of the table represent the market
connectedness with itself and are not particularly useful in our context. The
elements of the matrix which are off the diagonal measure the pairwise volatility
directional connections and are important for our study. First column measures the
directional connectedness from Crude Oil to all other commodities and energy
indexes in Americas, Europe, Asia Pacific and EMEA. Similarly, the first row of the
table measures the directional connectedness into the crude oil from all other
commodity markets and energy indexes in different regions. The highest volatility
connectedness of around 25% is observed from Americas Electricity index to
Americas Gas index (See eighth column, twelfth row). In return the connectedness
from Americas Gas index to Americas Electricity index is 24.67(See twelfth column,
eighth row). The difference between the two pairwise connectedness measures
implies that the net pairwise connectedness is almost nil.
The second highest connectedness is seen to Europe Electricity index from EMEA
Electricity index with a value of around 20.74% (ninth row eleventh column). The
connectedness from Europe Electricity index to EMEA Electricity index is 20.67%
(eleventh row ninth column). Hence the net connectedness in this pair also comes
close to nil. These two cases show that none of the index is a net transmitter of
shocks to the other market.
The Third highest connectedness is seen from heating oil commodity index to
gasoline commodity index with a value of 20.01% (third row fourth column). In
return the connectedness from gasoline commodity index to heating oil commodity
index is 17.41% (fourth row third column). The difference between the two pairwise
connectedness implies that the net pairwise connectedness is from heating oil
volatility to gasoline volatility.
Also we can see that the net pair wise connectedness is from crude oil to Asia
pacific indexes (electricity index 0.88 and gas index 1.02) while the net pair wise
connectedness is from Europe and EMEA to crude oil. Similar pattern is observed for
gasoline and heating oil where the net connectedness is from the commodity to the
Asia pacific indexes. This could be because of the high dependence of Emerging
countries in the Asia pacific region on these fuel sources for meeting their energy
requirements. While the same isnt seen for coal and Asia Pacific indexes as these
countries are major producers of coal and not heavily dependent on imports of the
commodity. The net pairwise connectedness for EUA is from Europe (Electricity
index 2.58 and Gas index 2.49) and EMEA index (Electricity index 2.64 and Gas
index 1.52).
It is worth to mention here that while the return transmission from oil and equities
can have a positive or a negative impact, the risk transfer has always a negative
influence as it increases uncertainty in the receiving markets.
The row sum of the pairwise connectedness measures the aggregate contribution
from all others to each of the fifteen indexes in the study (the total directional
connectedness). In other words, the contribution from others in the last column of
the matrix is the sum of the volatility transmission from all indexes to a particular
index. Similarly, the column sum of all pairwise connectedness measures the total
directional connectedness to others from the corresponding index. This means that
the contribution to others is the sum of pairwise directional transmission of implied
volatility from a particular market to all other indexes.
The crude oil implied volatility contribution to the volatility of all markets in the
system amounts to 70.32% while oil volatility only receives a 68.54% contribution
from others. In that sense, it is regarded as a transmitter of shocks but a very weak
one. In the system of indexes that we have, the Europe, Americas and EMEA indexes
are the indexes of the fifteen under study in which the contribution to others'
connectedness is higher than the contribution from others connectedness. The
positive net connectedness of the Europe gas index with all others is 21.60%,
indicating that it is a net transmitter of volatile shocks to the others. Similarly, for
the Europe electricity index net positive connectedness of 18.15% with all other
indicate that it is a transmitter of volatile shocks to the others. Same conclusion can
be drawn for EMEA gas index, EMEA electricity index, Americas gas index, Americas
electricity index, Heating oil index and Crude oil index. The net connectedness of
the rest of indexes is negative, which indicates that they are net recipients of
volatility shocks from other markets. Among the markets that have negative net
total connectedness, Asia Pacific electricity index has the highest value at 25.27%
followed by Asia Pacific Gas index 23.41%, EUA index 15.85%, Natural gas
hennery hub index 8.73%, Gasoline index 8.35%.
The total connectedness of implied volatilities that is reported in the lower right
corner of the table is 54.31%. This is a relatively high value but given the period of
study contains several stress period such as the financial crisis in 2008, the
European sovereign debt crisis following the Greek crisis in late 2009 and early
2010, the US fiscal cliff and the oil price collapse, there is a high degree of
connectedness in the sample Another reason for total connectedness being on the
higher side is that the connectedness of implied volatilities measures fear
connectedness in addition to volatility association. In volatile markets, options are
priced with higher volatilities than the expected volatility. Hence, the implied
volatility association not only reflects volatility crossovers but also the fear premium
transmissions among markets.
Dynamic volatility connectedness analysis
 BEELECT Index Europe BEGAS Index Europe BEUELEC Index EMEA
90 90 90

85
85 85

80
80 80
75
75 75
70

70 70
65

65 60 65
08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16

BEUGAS Index EMEA BPRELEC Index Asia Pacific BPRGAS Index Asia Pacific
90 100 90

85
80
80
80

75 70
60
70 60
65
40
50
60

55 20 40
08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16

BUSELEC Index Americas BUSGAS Index Americas CAR1 Comdty CER ICE
90 90 100

80
80 80

60
70 70
40

60 60
20

50 50 0
08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16

CL1 Comdty Crude Oil WTI NYM HO1 Comdty Heating Oil MO1 Comdty EUA ICE 1M
90 90 100

80 80
80

70 70
60
60 60

40
50 50

40 40 20
08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16

NG1 Comdty Natural Gas Henery Hub XA1 Comdty Coal Rotterdam XB1 Comdty Gasoline
70 80 90

60 70
80

50 60
70
40 50
60
30 40

50
20 30

10 20 40
08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16

Table 6 Total directional connectedness from others

 BEELECT Index Europe BEGAS Index Europe BEUELEC Index EMEA
140 140 140

120
120 120

100
100 100
80

80 80
60

60 60 40
08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16

BEUGAS Index EMEA BPRELEC Index Asia Pacific BPRGAS Index Asia Pacific
120 120 100

100
80
100
80
60
80 60
40
40
60
20
20

40 0 0
08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16

BUSELEC Index Americas BUSGAS Index Americas CAR1 Comdty CER ICE
120 140 200

120
100 150

100
80 100
80

60 50
60

40 40 0
08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16

CL1 Comdty Crude Oil WTI NYM HO1 Comdty Heating Oil MO1 Comdty EUA ICE 1M
120 120 160

100
100 120

80
80 80
60

60 40
40

20 40 0
08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16

NG1 Comdty Natural Gas Henery Hub XA1 Comdty Coal Rotterdam XB1 Comdty Gasoline
80 80 140

120
60 60
100

40 40 80

60
20 20
40

0 0 20
08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16

Table 7 Total directional connectedness to others

 BEELECT Index Europe BEGAS Index Europe BEUELEC Index EMEA
40 60 40

30
30
40
20
20
20 10
10
0
0
0
-10

-10 -20 -20

08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16

BEUGAS Index EMEA BPRELEC Index Asia Pacific BPRGAS Index Asia Pacific
30 60 20

20 40
0
10 20

0 0 -20

-10 -20
-40
-20 -40

-30 -60 -60

08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16

BUSELEC Index Americas BUSGAS Index Americas CAR1 Comdty CER ICE
60 60 150

100
40 40

50
20 20
0

0 0
-50

-20 -20 -100

08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16

CL1 Comdty Crude Oil WTI NYM HO1 Comdty Heating Oil MO1 Comdty EUA ICE 1M
60 40 120

40
20 80

20
0 40
0

-20 0
-20

-40 -40 -40

08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16

NG1 Comdty Natural Gas Henery Hub XA1 Comdty Coal Rotterdam XB1 Comdty Gasoline
20 40 60

20 40
0

0 20
-20
-20 0

-40
-40 -20

-60 -60 -40

08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16 08 09 10 11 12 13 14 15 16

G
E
S
U
B
7
6
8
5
9
0p
s
a
c
A
x
n
ty
d
m
o
1
L
C
2
3
4
M
Y
IN
T
ilW
O
efTable 8 Net Pairwise directional connectedness
P
R
ru
H
g
b
X
 Total Connectedness
80

75

70

65

60

55

50
08 09 10 11 12 13 14 15 16
Table 9
Total volatility connectedness
 A101 A102 A103 A104 A105 A106 A107 A108 A109 A110 A111 A112 A113 A114 A115
60 12 30 30 8 12 10.0 10.0 12 12 10.0 15 15 8 10.0

6 7.5 7.5 7.5 6 7.5

40 8 20 20 8 8 8 10 10
4 5.0 5.0 5.0 4 5.0
20 4 10 10 4 4 4 5 5
2 2.5 2.5 2.5 2 2.5

0 0 0 0 0 0 0.0 0.0 0 0 0.0 0 0 0 0.0

10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15

A116 A117 A118 A119 A120 A121 A122 A123 A124 A125 A126 A127 A128 A129 A130
16 100 20 16 15 12 12 12 10.0 15 12 10.0 10.0 12 10.0

12 80 15 12 7.5 7.5 7.5 7.5

10 8 8 8 10 8 8
8 60 10 8 5.0 5.0 5.0 5.0
5 4 4 4 5 4 4
4 40 5 4 2.5 2.5 2.5 2.5

0 20 0 0 0 0 0 0 0.0 0 0 0.0 0.0 0 0.0

10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15

A131 A132 A133 A134 A135 A136 A137 A138 A139 A140 A141 A142 A143 A144 A145
40 12 60 30 8 12 30 12 10.0 12 10.0 10.0 15 8 10.0

30 6 7.5 7.5 7.5 6 7.5

8 40 20 8 20 8 8 10
20 4 5.0 5.0 5.0 4 5.0
4 20 10 4 10 4 4 5
10 2 2.5 2.5 2.5 2 2.5

0 0 0 0 0 0 0 0 0.0 0 0.0 0.0 0 0 0.0

10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15

A146 A147 A148 A149 A150 A151 A152 A153 A154 A155 A156 A157 A158 A159 A160
28 12 30 60 10.0 15 30 12 10.0 15 10.0 12 15 10.0 10.0

24
7.5 7.5 7.5 7.5 7.5
8 20 40 10 20 8 10 8 10
20
5.0 5.0 5.0 5.0 5.0
16
4 10 20 5 10 4 5 4 5
2.5 2.5 2.5 2.5 2.5
12

8 0 0 0 0.0 0 0 0 0.0 0 0.0 0 0 0.0 0.0

10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15

A161 A162 A163 A164 A165 A166 A167 A168 A169 A170 A171 A172 A173 A174 A175
8 12 12 15 80 15 10.0 15 12 15 12 12 15 12 12

6 7.5
8 8 10 60 10 10 8 10 8 8 10 8 8
4 5.0
4 4 5 40 5 5 4 5 4 4 5 4 4
2 2.5

0 0 0 0 20 0 0.0 0 0 0 0 0 0 0 0
10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15

A176 A177 A178 A179 A180 A181 A182 A183 A184 A185 A186 A187 A188 A189 A190
15 8 15 12 10.0 80 40 10.0 15 12 12 12 12 10.0 10.0

6 7.5 60 30 7.5 7.5 7.5

10 10 8 10 8 8 8 8
4 5.0 40 20 5.0 5.0 5.0
5 5 4 5 4 4 4 4
2 2.5 20 10 2.5 2.5 2.5

0 0 0 0 0.0 0 0 0.0 0 0 0 0 0 0.0 0.0

10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15

A191 A192 A193 A194 A195 A196 A197 A198 A199 A200 A201 A202 A203 A204 A205
12 12 12 15 10.0 60 100 12 15 15 15 12 12 15 15

80
7.5
8 8 8 10 40 8 10 10 10 8 8 10 10
60
5.0
40
4 4 4 5 20 4 5 5 5 4 4 5 5
2.5
20

0 0 0 0 0.0 0 0 0 0 0 0 0 0 0 0
10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15

A206 A207 A208 A209 A210 A211 A212 A213 A214 A215 A216 A217 A218 A219 A220
10.0 6 12 12 8 8 8 50 15 10.0 12 50 15 8 12

7.5 6 6 6 40 7.5 40 6
4 8 8 10 8 10 8
5.0 4 4 4 30 5.0 30 4
2 4 4 5 4 5 4
2.5 2 2 2 20 2.5 20 2

0.0 0 0 0 0 0 0 10 0 0.0 0 10 0 0 0
10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15

A221 A222 A223 A224 A225 A226 A227 A228 A229 A230 A231 A232 A233 A234 A235
10.0 6 10.0 10.0 8 8 30 12 40 10.0 30 12 20 10.0 25

7.5 7.5 7.5 6 6 7.5 25 7.5 20

4 20 8 30 8 15
5.0 5.0 5.0 4 4 5.0 20 5.0 15
2 10 4 20 4 10
2.5 2.5 2.5 2 2 2.5 15 2.5 10

0.0 0 0.0 0.0 0 0 0 0 10 0.0 10 0 5 0.0 5

10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15

A236 A237 A238 A239 A240 A241 A242 A243 A244 A245 A246 A247 A248 A249 A250
12 8 10.0 10.0 12 20 12 15 12 80 12 15 12 30 12

6 7.5 7.5 60
8 8 8 10 8 8 10 8 20 8
4 5.0 5.0 10 40
4 4 4 5 4 4 5 4 10 4
2 2.5 2.5 20

0 0 0.0 0.0 0 0 0 0 0 0 0 0 0 0 0
10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15

A251 A252 A253 A254 A255 A256 A257 A258 A259 A260 A261 A262 A263 A264 A265
10.0 8 8 12 8 10.0 30 12 28 10.0 40 10.0 20 10.0 20

7.5 6 6 6 7.5 24 7.5 7.5 7.5 16

8 20 8 30 15
5.0 4 4 4 5.0 20 5.0 5.0 5.0 12
4 10 4 20 10
2.5 2 2 2 2.5 16 2.5 2.5 2.5 8

0.0 0 0 0 0 0.0 0 0 12 0.0 10 0.0 5 0.0 4

10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15

A266 A267 A268 A269 A270 A271 A272 A273 A274 A275 A276 A277 A278 A279 A280
12 6 12 12 6 8 8 40 15 12 12 50 15 8 12

6 6 40 6
8 4 8 8 4 30 10 8 8 10 8
4 4 30 4
4 2 4 4 2 20 5 4 4 5 4
2 2 20 2

0 0 0 0 0 0 0 10 0 0 0 10 0 0 0
10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15

A281 A282 A283 A284 A285 A286 A287 A288 A289 A290 A291 A292 A293 A294 A295
15 6 10.0 12 8 10.0 30 15 20 8 20 15 40 8 20

7.5 6 7.5 6 16 6 16
10 4 8 20 10 16 10 30
5.0 4 5.0 4 12 4 12
5 2 4 10 5 12 5 20
2.5 2 2.5 2 8 2 8

0 0 0.0 0 0 0.0 0 0 8 0 4 0 10 0 4
10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15

A296 A297 A298 A299 A300 A301 A302 A303 A304 A305 A306 A307 A308 A309 A310
15 6 12 10.0 15 12 20 20 15 30 15 20 15 60 10.0

7.5 15 15 15 7.5
10 4 8 10 8 10 20 10 10 40
5.0 10 10 10 5.0
5 2 4 5 4 5 10 5 5 20
2.5 5 5 5 2.5

0 0 0 0.0 0 0 0 0 0 0 0 0 0 0 0.0
10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15

A311 A312 A313 A314 A315 A316 A317 A318 A319 A320 A321 A322 A323 A324 A325
12 8 12 8 8 8 30 15 20.0 10.0 24 12 20 10.0 50

6 6 6 6 17.5 7.5 20 7.5 40

8 8 20 10 8 15
4 4 4 4 15.0 5.0 16 5.0 30
4 4 10 5 4 10
2 2 2 2 12.5 2.5 12 2.5 20

0 0 0 0 0 0 0 0 10.0 0.0 8 0 5 0.0 10

10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15 10 15

Table 10 Pairwise dynamic connectedness

Empirical Results
Dynamic volatility connectedness analysis
The static connectedness analysis provides a good picture of the connectedness of
the implied volatilities over the period of Apr-2008 to May-2016. Although to better
understand the change in connectedness over time, we observe the extent and
nature of connectedness over time using the total directional connectedness
graphs. Table 7 presents plots of total directional connectedness of implied volatility
originating from the corresponding gas, coal, electricity & commodity markets, and
transmitting to other equity markets. Table 6 presents the transmissions of implied
volatility in the opposite direction (i.e. from all equity markets to the corresponding
gas, coal, commodity and electricity markets). Table 8 depicts the net pair-wise
directional dynamic connectedness of the corresponding coal, gas, electricity and
commodity volatilities with the volatility of each of the equity markets over the
sample period.

It can be seen from the above graphs that for electricity, the connectedness is
largely dominated by information transmission from electricity to other equities in
Europe and EMEA region whereas in Asia pacific it is the other way round. The
directional connectedness for Europe and EMEA indices to others is of the order of
100s whereas that in the opposite direction is of the order of 10s. Although for the
U.S market there is no clear dominance of the directional connectedness over time
and the connectedness is time varying.

For gas, for the European market, the connectedness is again dominated by the
transmission of volatilities in gas to other equities and that in Asia-Pacific region is
dominated by the transmission of volatilities in other equities to gas. In the EMEA
region the directional connectedness is time varying from 2008-2011. 2011-12 saw
a strong dominance of transmission of information from gas to other equities
followed by 2 years of time varying connectedness. Although, connectedness from
gas to other equities has been strong thereafter. In the American market, the
connectedness from gas to other equities has been dominating except for 2008-9
and 2012-13 which were marked my recession in the American as well as global
markets.

As shown in the graphs, the connectedness NG1 Comdty Natural Gas, XA1 Comdty
Coal Rotterdam, CAR1 Comdty CER ICEand MO1 Comdty EUA ICE 1M show net
directional connectedness which is dominated by the transmission of volatilities
from other equities to them. The former two show strong domination as compared
to the latter.

For CL1 Comdty Crude Oil WTI NYM and HO1 Comdty Heating Oil, the net pairwise
transmissions from oil to equities is positive, this indicates that the risk transfer
between crude oil and heating oil and the equities is asymmetric and dominated by
volatilities from oil markets. Thus we can conclude that Comdty Crude Oil WTI NYM
and HO1 Comdty Heating Oil is significant to establish association with other equity
markets.
If we see in Table 8 Net Pairwise directional connectedness, oil played quite
an important role in the commodity market connectedness. Its net connectedness is
higher than all other commodities for majority of the sample time window
considered. Both in earlier and later parts of the period, net connectedness of oil
reached as high as 35-40% range. The only sub-periods during which the net
connectedness of crude oil was lower are the second half of 2008, and the period
from the second half of 2012 to August 2015. Starting in the first quarter of 2008,
WTI crude oil price skyrocketed from around $60 in February 2007 to reach $141 per
barrel by the first week of July 2008. After that moment, however, the oil price
started to come down as the worries about the US economic performance
intensified along with the signs of slowdown in many countries. By the end of
October 2008, WTI oil price went down to $60 per barrel. However, the downward
spiral in the price of oil continued until the third week of December, with a minimum
price of $31 per barrel. As the oil price lost its downward momentum, the net
connectedness of oil dropped to around 10% by the end of 2008.
If we see in Table 10 Pairwise dynamic connectedness, Gasoline and Heating
oil are the other two commodities that followed crude oil in generating very high
levels of net connectedness to other commodities over all subsamples considered.
Heating oil and Gasoline are in the energy commodities group. their net
connectedness to others follows a trajectory which resembles to that of crude oil.
Gasoline net connectedness reached as high as 47% in May 2008. The energy
commodities that are a net recipient of connectedness from others are natural gas
and coal. Literature on energy markets pinpoints natural gas as the only energy
market with the weakest link to the economic news flow, even when accounting for
periods of recession. Reflecting this fact, its connectedness to others and from
others are much lower than those of other energy commodities (see Table 6 and
Table 7). As such its return volatility is likely to be affected from the return
volatilities of other energy commodities. That is why its net connectedness was
negative for a majority of sample windows (see Table 8).
Table 9 (Total volatility connectedness) shows that the total connectedness of
implied volatilities is time varying. Three cycles of connectedness can be spotted in
the graph. The first cycle is in the period of 2008-11 where the total connectedness
of implied volatilities shows peaks with the values ranging from 64 to 78. This high
value is due to lots of financial stress events happening over the period such as the
financial crisis in 2008, the Greek crisis & European sovereign debt crisis in late
2009 and early 2010. The economic uncertainty due to these events affected the
implied volatilities in the market. The period of 2012-13 and early 2014 show these
value settling to sub 60 levels. This the second cycle & corresponds to the period of
recovery in the global economy These values again rise from mid-2014 to 2016 in
the period corresponding to the third cycle. This coincides with the collapse in oil
prices starting June 2014 and period of uncertainty in oil prices.

Conclusion
In this Paper, we analysed the relationships between electricity prices, primary
energies prices used in electricity generation and the price of carbon dioxide
emission permits in Americas, Asia Pacific, Europe & EMEA region. We studied the
implied volatilities in these markets in the period that followed the 2008 financial
crisis. In our study, the causality between the volatility of the fuel sources, energy
and carbon allowance index is derived from static models that cover the whole
sample period. Also, we have conducted the net pairwise directional dynamic
connectedness of each index in the study with the volatility of each of the other
index over the sample period.
In the directional dynamic connectedness, we have analysed the dynamics of
directional connectedness of individual index, commodities as well as commodity
groups. In Table 6,7 and 8, we presented total directional connectedness from
others, total directional connectedness to others and total directional net
connectedness of each commodity. Even though, we present all three graphs, our
main results were mostly based on net connectedness graph in Table 6
Our results indicate that the net pair wise connectedness is from crude oil to Asia
pacific indexes while the net pair wise connectedness is from Europe and EMEA to
crude oil. A similar pattern is observed for gasoline and heating oil where the net
connectedness is from the commodity to the Asia pacific indexes. Also, crude oil
here is the biggest transmitter of shocks compared to all other commodity indexes.
Other than crude oil the Europe gas index, EMEA gas index, EMEA electricity index,
Americas gas index, Americas electricity index, Heating oil index and Crude oil index
are also transmitters of shocks to other indexes in the study. The transmission
mechanism of information for these indexes is skewed in that the information
transmission from them to other index is larger than the transmission in the
opposite direction. Moreover, the pattern of transmission is found to be time varying
with large transmissions in the period that extends from the mid of 2008 to the mid
of 2011 & 2015 to 2016 period.
We recognize here the limitation of the short length of the period under study due
to the data availability. However, there are clear advantages of using implied
volatility over historical volatility in analysing the risk transfer. For instance, we find
that the analysis based on implied volatility differentiates the patterns of risk
transfer to developing countries versus developed countries. The extra information
disappears when historical volatility measures are used.

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