Geopolitical shocks and carbon pricing: Do clean energy assets act as a hedge?

Abstract

While the interaction between geopolitical events and emission trading system (ETS) is somewhat complex, very little is known about how geopolitical shocks impact global carbon prices. In this study, we extend this scant literature by exploring the linkage between geopolitical risk (GPR) and the Chinese carbon markets. Given that geopolitical shocks may influence the Chinese ETS in several ways, such linkage merits an empirical investigation. Methodologically, we combine the Markov regime switching (MRS) model with the vector autoregressive (VAR) process and apply it to the Shenzhen and Hubei carbon markets. The results suggest that while the standard VAR model fails to capture any connection between geopolitical shocks and carbon returns, employing the MRS-VAR process reveals that GPR in fact exerts significant effects on the Chinese carbon markets implying that such effects appear to be regime-dependent. More specifically, the impact of geopolitical shocks is negative in the high volatility regime, but statistically insignificant in the low volatility regime. Further investigations show that higher geopolitical risk leads to higher hedging costs and that clean energy equities could be a suitable hedge for the Chinese carbon markets amid the periods of high geopolitical uncertainties. These outcomes have key implications which would be crucial for reaching the net-zero goals.