Addressing COP21 using a Stock and Oil Market Integration Index Energy Policy

COP21 implementation should lead to a decline in the future demand for fossil fuels. One key implication for investors is how to best manage this risk. We construct a monthly integration index and then demonstrate that oil investors can offset adverse oil price risk by holding various global stock portfolios. The portfolios are formed from eight different combinations of developed and emerging stock markets. We show that measuring the degree of stock-oil market integration for these portfolios is critical to managing the time-varying degrees of integration that exist between oil and stock markets. Importantly, under normal market conditions, when markets are segmented, there is the opportunity for oil investors to diversify the additional energy price risk, caused by COP21, through the purchase of stocks. The optimal oil-stock diversified portfolio provides risk-adjusted positive benefits to investors, with the weightings changing over time as COP21 implementation proceeds.