Energy Finance: Background, Concept, and Recent Developments

Energy is a critical input in modern economic systems. Its influence on various parts of economic performance has been widely investigated. Traditionally, energy prices, such as oil prices, are considered to be determined by supply and demand in international markets. Hamilton (2009), for example, suggests that increasing demand in emerging economies (e.g., China), failure to increase oil supply, and low price elasticity are the main reasons for price increases before 2008.

Fundamental factors were important in understanding oil price changes prior to 2008. They largely failed to explain what happened afterward. The extremely volatile price dynamics cannot simply be due to changes in the fundamentals. Fattouh and Mahadeva (2012) provide an alternative explanation based on the notion of oil financialization—which has been explored intensively in the recent literature (see, e.g., Creti and Nguyen 2015; Zhang 2017; Zhang and Ji 2018). A large number of studies also investigate issues such as the relationship between energy price shocks and financial markets, financing and investment decisions made by energy firms, and carbon finance and green finance. These studies have naturally coalesced into a common research theme—energy finance, a subject of growing interest among academic researchers.

In addition, since the 2008 global financial crisis, international energy markets have become more closely linked with financial markets, and energy prices have exhibited more financial characteristics. As a result, it is critical to further study energy market issues from a financial perspective. Indeed, the strategic importance of energy and climate change gives financial issues a unique relevance for both academia and policy makers, which inevitably leads to a further separation of energy finance from general financial research.

The concept of energy finance, however, is vague and has no clear definition, which may create constraints on its further development. This special issue therefore aims to provide a platform for discussions on the most recent developments in energy finance and contribute to clarification of the concept of energy finance.

What Is Energy Finance?

Energy finance is inherently interdisciplinary. It starts with exploring the linkages between energy markets and financial markets but then requires us to look at energy products/markets from a financial perspective. To further clarify this concept, we elaborate on the following six broad themes based on a brief review of the relevant literature, though the concept is not limited to them.

Energy and Financial Markets

Chen, Roll, and Ross (1986) are perhaps the first to investigate the role of oil price risk in stock markets, though their findings do not support a separate role for oil. Jones and Kaul (1996) investigate the reaction of international stock markets to oil shocks in a number of developed economies and confirm the significant role of oil shocks in stock returns. However, they show that changes in cash flows or expected returns are not sufficient to justify stock price reactions. Huang, Masulis, and Stoll (1996) and Sadorsky (1999) use oil futures prices as a proxy for energy market and show that it is linked to stock markets. These earlier studies led to a wide variety of research investigating the relationship between oil shocks and financial markets, from developed economies to emerging markets. Broadstock et al. (2014) discuss the mechanism of oil price shocks to stock markets using the capital asset pricing model and propose the idea of a direct and indirect impact from oil to stock prices. They suggest considering asset pricing models as a starting point, rather than a purely statistical approach, to understand the role of oil shocks to financial markets. Zhang (2017) uses a time-varying approach and shows that structural changes exist and that oil prices have received more information from global financial markets since 2008.

Pricing Mechanisms

Pricing is always an important issue in energy markets. Energy price movements are often considered a critical component that affects economic output. The question is: How are energy prices formed? Because energy is a special kind of commodity, market supply and demand are naturally considered most relevant in energy pricing. The standard pricing mechanism has been challenged by recent evidence of financialization (Cheng and Xiong 2014). In other words, energy commodities appear to have characteristics that resemble those of financial products. Cross-market (Weiner 1991; Zhang and Ji 2018) and cross-regional (Zhang, Shi, and Shi 2018) studies incorporate the new characteristics of energy commodities. The development of new statistical models (e.g., a dynamic model averaging technique) allows people to empirically investigate the formation of energy prices in a dynamic manner.

Energy Corporate Finance

One recent advance in energy finance is research on understanding energy firms’ financing and investment decisions. As outgrowths of mainstream corporate finance literature, these studies start with the assumption that energy firms are unique and worthy of being investigated separately from other industries. Jensen (1986) suggests that oil companies tend to hold large volumes of cash and invest in poor-quality projects. Based on this observation, he raises the famous free cash flow (FCF) problem, which led to the widely discussed agency problem. In terms of energy-related studies, Griffin (1988) tests the FCF hypothesis using data from petroleum firms. Lamont (1997) finds that oil firms’ reaction to oil price shocks is consistent with the agency cost hypothesis. Zhang et al. (2016a), (2016b), using energy firms and renewable energy firms in China as examples, show that their investment decisions can be irrational, which leads to overinvestment at the expense of shareholders. The strategic importance of energy around the world and the firm as the entity to execute a country’s energy development policy have increased the need to study and understand financing and investment decisions at energy-related firms.

Green Finance and Investment

In reaction to the threat of global warming, there is an increasing demand for developing renewable energy to reduce greenhouse gas emissions. China, following the development in Europe of an emission trading scheme (ETS), has established its own ETS, which raises important questions about carbon financing and carbon pricing. Bredin, Hyde, and Muckley (2014), for example, study the European carbon finance market using high-frequency data and investigate the role of market microstructure. Kanamura (2016) examines the role of carbon swaps.

Related to setting up a carbon market, around the world green finance and investment have also become a strategically important trend. In April 2000, the World Bank established the first carbon fund (Zhang 2006). China, the biggest market for green-labeled bonds, has also designed clear targets for establishing a green financing system, which offers investors and the renewable energy industry a great opportunity (Lewis 2010). How banks and monetary authorities respond to the development of a carbon market is also critical in promoting low carbon investment (Campiglio 2016).

Energy Derivative Markets

One of the main reasons for financialization in the energy market is the development of markets for energy derivatives. This gives studies on the issues involved in markets for energy derivative a special role. Derivatives were first conceived as instruments for hedging against risk, though some people believe that the associated speculative investment can cause additional volatility in spot markets. Fleming and Ostdiek (1999) show evidence disproving the idea that derivative markets can reduce volatility in spot markets for crude oil. Haigh and Holt (2002) examine the role of a number of energy futures in reducing volatility in spot prices and they find that futures markets can significantly reduce uncertainty. Kim (2015) studies the role of futures market during the recent period of financialization and finds that speculative trading is not necessarily responsible for market instability.

Derivatives can also help improve the price discovery process in energy markets. Lin and Tamvakis (2001), for example, find substantial spillover effects between futures markets in New York and London. Kang, McIver, and Yoon (2017) investigate dynamic spillovers among six commodity futures and show that the 2008 global financial crisis increased spillovers.

Energy Risk Management

Because energy commodities are imbued with financial characteristics, their risks and associated risk management are critical for both economic and policy reasons. Firms need to hedge against potential energy price variations, and the government needs to maintain energy security. Andriosopoulos, Galariotis, and Spyrou (2017), for example, investigate energy market contagion during the euro crisis period in 2012. A number of studies use typical risk management tools in financial markets to examine energy market risk. For example, Sadeghi and Shavvalpour (2006) use a value at risk model to evaluate energy market risks. Jackson (2010) suggests that using these financial models can help improve investment in energy efficiency.

Summary of Findings in the Special Issue

This special issue consists of ten papers covering all six categories in energy finance. Their main contributions and findings can be summarized as follows.

Chunyan Hu, Xinheng Liu, Bin Pan, Bin Chen, and Xiaohua Xia’s article (“Asymmetric Impact of Oil Price Shock on Stock Market in China: A Combination Analysis Based on SVAR Model and NARDL Model”) contributes to the literature on energy price shocks and financial market relationships by combining a structural VAR (SVAR) model and a nonlinear ARDL (NARDL) model. They allow the relationship to be asymmetric and consider both the short- and long-run effects. The general conclusion is that only the demand-side shocks matter.

In this same vein, Durmuş Çağrı Yildirim, Seyfettin Erdoğan, and Emrah İsmail Çevik (“Regime-Dependent Effect of Crude Oil Price on BRICS Stock Markets”) use a Markov-switching VAR model to investigate how much oil price shocks and stock markets are related in the BRICS (Brazil, Russia, India, China, and South Africa) countries. They find evidence of regime dependence and confirm the importance of demand-side shocks in these countries.

Umut Ugurlu, Oktay Tas, and Umut Gunduz (“Performance of Electricity Price Forecasting Models: Evidence from Turkey”) use Turkish electricity market as an example for evaluating the forecasting performance of a number of univariate models. High-frequency (hourly) electricity prices in the Turkish day-ahead electricity market are used in the empirical assessments. Their main contribution is showing that a factorial analysis of variance is useful technique for pre-whitening the price series before fitting it into a univariate time-series model.

Green investment is a major issue in China, and the government has made it a strategically important development target in the country’s 13 five-year plan (2016–2020). The objective is to establish a green financial system. Ling-Yun He and Li Liu’s research (“Stand by or Follow? Responsibility Diffusion Effects and Green Credit”) uses a panel of 443 listed firms in China to analyze private capital holders’ green investment behavior. Their main findings show that private capital holders tend to increase their green investment with better financial conditions and are encouraged by green credit offered by commercial banks.

Ali Kutan, Sudharshan Reddy Paramati, Mallesh Ummalla, and and Abdulrasheed Zakari (“Financing Renewable Energy Projects in Major Emerging Market Economies: Evidence in the Perspective of Sustainable Economic Development”) contribute to the literature on renewable energy development/financing. They use foreign direct investment inflows and stock market development as proxies and find that a statistically significant role is played by financial market conditions in promoting renewable energy consumption in four BRICS countries: Brazil, China, India, and South Africa.

Serdar Celik and Ayla Ogus Binatli (“Energy Savings and Economic Impact of Green Roofs: A Pilot Study”) use satellite views and image processing as instruments to determine the green roof implementation of a district in the southwestern Aegean region of Turkey. They then analyze energy savings and the associated economic impact. Their scenario analyses suggest that government support of green loans is important for the development of green roof retrofitting.

Erik Haugom, Guttorm A. Hoff, Peter Molnár, Maria Mortensen, and Sjur Westgaard’s study (“The Forward Premium in the Nordpool Power Market”) focuses on electricity spot prices and their relationship with the futures market. They investigate the question of what affects the forward premium of futures contracts in the Nordic power market. Based on data from January 2004 to December 2013, they first show that all forward premiums exist with seasonal patterns and then find that spot prices and the deviation of water inflow have a positive impact on forward premiums.

A. Can Inci and H. Nejat Seyhun (“Degree of Integration Between Brent Oil Spot and Futures Markets: Intraday Evidence”) evaluate the degree of integration between spot and futures prices of crude oil. Combining intraday Brent crude futures prices with daily Brent spot prices, this research contributes to the literature on price discovery of energy derivatives and the risk transmission mechanism. They confirm that the spot and futures markets are highly integrated and support market efficiency.

Bradley T. Ewing, Alper Gormus, and Ugur Soytas (“Risk Transmission from Oil and Natural Gas Futures to Emerging Market Mutual Funds”) focus on a volatility transmission mechanism between energy futures and 518 emerging market mutual funds (EMMFs). Using a nonlinear Granger causality test on volatility, they show that EMMFs respond to volatility in oil and natural gas markets. The findings of risk spillover have important implications for financial practitioners.

Wasim Ahmad and Shirin Rais (“Time-Varying Spillover and the Portfolio Diversification Implications of Clean Energy Equity with Commodities and Financial Assets”) take a time-series approach to investigate the time-varying spillover of a clean energy index and a number of energy and financial assets. They find that the clean energy index is more relevant to the indices of financial assets related to energy prices. They reinforce the previous discussion on energy financialization and have important implications for energy risk management.

Concluding Remarks

In general, energy finance is a newly developed interdisciplinary area. It has attracted great interest in the recent literature and has great potential for academic research. Given the strategic importance of energy and the global environmental challenges, both policy makers and investors have also shown great interest in understanding energy finance. This special issue helps us to advance our understanding of the concept and special features of energy finance, though many challenges remain.

We can point to a few promising, yet unexplored directions for further research. First, some newly developed methods, such as big data and machine learning, should be considered in future studies on energy finance topics. Second, corporate finance in energy is still understudied. Further justification of the uniqueness of energy firms is needed. Cross-country comparison and deep exploration of corporate governance systems are necessary to understand energy firms’ financing/investment decision-making process. Third, environmental accounting, corporate social responsibility, and green development are closely related but largely missing from the existing energy finance literature. The rapid progress of green bond markets needs more investigation. Fourth, some exciting developments are taking place in emerging economies, such as China. For example, the launch of a nationwide ETS at the end of 2017 and trading in crude oil futures in 2018 have raised numerous questions. Both practitioners and policy makers need more information and academic support to understand the market developments. Last but not the least, researchers interested in this area may need to work together to establish a general framework for future development of energy finance.

Acknowledgments

Given the space constraints, we could not include all the good papers we received in this special symposium section. I sincerely thank all the authors who generously shared their invaluable ideas in this issue. Special thanks are due to Ali Kutan, the editor of Emerging Markets Finance & Trade, the reviewers, and others who helped make this special issue possible.

Additional information

Funding

I acknowledge financial support received from the National Natural Science Foundation of China (NSFC) under grant number 71573214 and the 111 Project under grant number B16040.