Decomposing return and volatility connectedness in Northwest European natural gas markets: Evidence from the R2 connectedness approach

Regulatory reforms by the European Commission have facilitated the integration of European natural gas markets, thereby increasing their mutual interdependence in terms of prices and associated risks. Recent external shocks, including the COVID-19 pandemic and the Russian invasion of Ukraine, have disrupted market interconnectedness, as documented in the literature. However, the nature of shock transmission, whether contemporaneous or delayed, during periods of market instability, the subsequent speed of recovery in price and volatility connectedness, and the potential differences between spot and futures prices have not yet been investigated. This paper addresses these issues in two steps. First, it quantifies the dynamics of return and volatility connectedness among Northwest European gas hubs using the R2 decomposition connectedness method. Second, it explains these dynamics by linking fluctuations in connectedness to physical, policy, and macroeconomic factors using a regression-based framework. Our findings show that contemporaneous spillovers dominate lagged spillovers, even during external shocks, indicating rapid market adjustments. Moreover, while market connectedness declined significantly during major disruptions, it promptly returned to pre-crisis levels once these disruptions subsided. Futures markets showed higher connectedness than spot markets during tight conditions, suggesting greater alignment with broader market expectations and reduced susceptibility to physical constraints. Furthermore, regression analysis indicates that return and volatility connectedness decline significantly when certain pipelines are congested, whereas congestion on other links has no clear effect.