Carbon Pricing Uncertainty and the Green Finance Ecosystem: Connectedness, Contagion, and Portfolio Strategies

Carbon price instability within the EU Emissions Trading System (EU ETS) is associated with financial stress that propagates across green finance markets, yet the system-level dynamics linking carbon allowance instruments, clean energy equities, green bonds, and oil volatility remain insufficiently characterized over the turbulent 2021–2026 period. This paper applies the DCC-GARCH R2 decomposed connectedness framework to five exchange-traded funds and one volatility index spanning the principal channels through which EU ETS regulatory shocks propagate to financial markets, and derives a novel Connectedness-Based Hierarchy Index (CBHI) that translates the transmitter–receiver hierarchy into a time-varying portfolio desirability index. Five key findings emerge. First, the carbon allowance futures ETF (KRBN) and the Paris-aligned equity ETF (CARB) form a near-closed systemic bloc within this asset universe: bilateral connectedness reaches 0.867, with to and from directional connectedness values both approaching 80%. Second, this co-transmitter structure is highly contingent on the joint inclusion of both instruments; excluding CARB raises KRBN’s CBHI from 0.251 to 22.204, reclassifying it as a structural diversifier and reducing the mean Total Connectedness Index (TCI) from 52.18% to 30.81%. Third, system-wide connectedness averages 52.18% but surges to nearly 73% during EU ETS regulatory crises. Fourth, connectedness-aware portfolios outperform the minimum-variance benchmark across all risk-adjusted metrics, yielding an annualized Sharpe ratio of 0.148 vs. −1.066 (T=1035 observations, daily rebalancing, zero transaction costs); this improvement is driven by reallocation toward crude oil volatility (OVX), the sole non-ETF and most peripheral instrument (to = 5.55%, CBHI=14.310), which the CBHI identifies as the system’s dominant structural diversifier and whose weight rises from 0.4% in the benchmark to 31.6%. Fifth, the CBHI uncovers a structural tension in Paris-aligned mandates: CARB records the second-lowest CBHI (0.254), indicating that climate alignment and systemic risk minimization are partially conflicting objectives.