Crude oil price volatility—An unintended consequence of carbon pricing: Evidence from transfer entropy and wavelet-partial wavelet coherence analyses

Abstract

The urgent need to achieve the COP-27 targets has become evident due to the more frequent and severe climate-induced disasters and their socioeconomic consequences. The adverse effects of climate change highlight the need for an immediate shift away from fossil fuels without compromising economic development. Internalization of the negative externality in market transactions through the imposition of carbon pricing is widely touted as the most economically efficient means of solving this problem. This study, however, argues that crude oil price volatility could be an unintended consequence of carbon pricing. To this end, information flows between the European Union Emissions Trading Scheme and crude oil price volatility are examined through transfer entropy and wavelet-partial wavelet coherence analyses. Daily data from January 1, 2014 to July 1, 2023 are analyzed. The transfer entropy results show that information on carbon pricing reduces uncertainty about crude oil price volatility and vice versa, indicating that carbon pricing would be quite informative in building models to predict crude oil price volatility. The wavelet-partial coherence analyses reveal that the surge in carbon prices experienced in the late 2010s induced crude oil volatility, whereas the crude oil price volatility triggered by the COVID-19 pandemic forced carbon prices down. This study therefore identifies carbon price movements as a legitimate fear for policymakers, as it is a new source of volatility in conventional energy markets. Caution should thus be the watchword regarding optimal carbon pricing. Aiming to rapidly attain the full optimal carbon price is not recommended. Rapid changes in carbon prices will have strong redistributive implications across economies.