Downside risks in EU carbon and fossil fuel markets

The European Union carbon market is undergoing rapid development and its interdependence with fossil fuel markets is increasingly important for energy investors. In this study, exponential general autoregressive conditional heteroskedastic models, extreme value theory and copulas are used to evaluate downside risk through the traditional value-at-risk and expected shortfall measurements. Empirical evidence for daily data from January 2008 to October 2012 indicates that the carbon market has more downside risks than the oil market but fewer than the gas market. Copula analysis provides evidence of positive average dependence and extreme symmetric market independence between the carbon and oil markets, and average and extreme independence between the carbon and gas markets. The implications of these results for portfolios consisting of European Union Allowances and fossil fuels point to the existence of downside risk gains. The carbon market is therefore an attractive market for investors in terms of risk management.