Carbon Emission Allowance and Oil Implied Volatility

Abstract

This study develops a theoretical model to link carbon emission allowance (CEA) prices to oil implied volatility. The model identifies two channels: an explicit channel where rising CEA prices increase production costs, inventory, and option hedging demand while reducing speculating demand, leading to a negative price effect; and an implicit channel where higher CEA prices signal future oil price increases, boosting option hedging demand and futures speculating demand resulting in a positive price effect. These dynamics create a U-shaped relationship between CEA prices and implied volatility. Empirical analysis in Chinese markets confirms this U-shaped relationship and the Granger causality of CEA prices. The findings from the seven trial markets suggest that the U-shape is primarily driven by the hedging demand of company headquarters in Beijing and Shanghai. Additionally, we find that CEA prices influence expected volatility and option demand, with a U-shaped effect on expected volatility and no impact on unexpected volatility. Higher CEA prices also increase futures speculation demand while leaving futures hedging demand unchanged. Furthermore, this study reveals that CEA prices Granger-cause West Texas Intermediate futures volatility and the aggregate effect of CEA prices on oil implied volatility reflects the combined impact of hedging and speculating demands in the option and futures markets and international oil volatility.