A conditional dependence approach to CO2-energy price relationships

This paper uses the conditional vine copula approach to model the dependence structure between European-based carbon allowances and major energy prices. It makes two central contributions to the related literature. First, we extend the previous works of Reboredo (2013, 2014) by allowing for complete coverage of energy markets including natural gas, coal, and electricity, beyond the carbon-oil dependencies. Second, we simultaneously investigate the multivariate dependence among all variables in the system so that each of them can interact with the others based on a rich variety of bivariate copula functions. The consideration of the electricity market in this context offers the possibility to gauge its influences through the computation of the fuel-switching mechanism. We mainly find that there is a reliable and positive link between coal and gas prices, and between coal and oil prices, with or without the presence of electricity prices, while a weak and positive link is detected between Brent and gas prices. Carbon prices co-move only weakly with energy prices, and their link to oil and gas prices is negative. Moreover, the switch from coal to gas does not occur when the relative price of fuels taking into account carbon costs is assessed. This happens because the fuel-switching mechanism is still more costly than carbon abatement. Our findings remain intact when alternative electricity prices are used.