Can energy commodities hedge EU emission allowance futures? Evidence from time-varying copulas using mixture marginal distributions

We examine how energy commodities can effectively mitigate the risks associated with European Union allowance futures. The hedging portfolios comprise long positions in carbon assets and short positions in major energy commodities. Enhancing the effectiveness of risk hedging depends on precisely modeling return distributions and the adaptive adjustment capability of the model structure. To this end, we propose utilizing flexible normal mixture distributions as marginal distributions in conjunction with copula models featuring time-varying parameters. Empirical results show that our model outperforms the time-varying copula with t-margins and the static copula with normal mixture margins in hedging performance. Furthermore, the improvement in hedging effectiveness remains robust in out-of-sample forecasts. When considering transaction costs, our strategy remains economically viable. Considering the impact of the COVID-19 pandemic and the Russia–Ukraine conflict, we compare hedging ratios and effectiveness across various phases. Our findings suggest that natural gas futures are the most effective hedge before the outbreak of the Russia–Ukraine conflict. During COVID-19, the hedging effectiveness of gas and oil futures increases. Following the conflict, the hedging strategy temporarily shifts to hedging EUAs with long natural gas futures between March and April 2022. However, between February and March 2022, and between April 2022 and February 2023, oil futures are the most efficient tool. After March 2023, shorting natural gas once again becomes the most effective hedging strategy.