The predictability of carbon futures volatility: New evidence from the spillovers of fossil energy futures returns

Abstract

In this paper, we find new evidence for the carbon futures volatility prediction by using the spillovers of fossil energy futures returns as a powerful predictor. The in‐sample results show that the spillovers have a significantly positive effect on carbon futures volatility. From the out‐of‐sample analysis with various loss functions, we find that fossil energy return spillovers significantly outperform the benchmark and show better forecasting performance than the competing models using dimension reduction, variable selection, and combination approaches. The predictive ability of the spillovers also holds in long‐term forecasting and does not derive from other carbon‐related variables. It can bring substantial economic gains in the portfolio exercise within carbon futures. Finally, we provide economic explanations on the predictive ability of the fossil energy return spillover by the channels of the carbon emission uncertainty and the investor sentiment on the warming climate.