To further understand a country’s level of exposure to oil price uncertainty, we consider its **energy generating portfolios** (‘energy mix’), which contain elements of higher and lower price volatility. Broadly speaking, all fossil fuels (mainly coal, natural gas, crude oil) are highly price volatile, as they are sensitive to exogenous supply shocks. As most countries strongly rely on fossil fuels as their main energy source<sup>11</sup> (globally 87%), they are thought to ‘import’ this uncertainty from global markets into their national generating portfolios. As fossil fuels are highly cross-correlated (cf. Table 8), reducing the percentage of oil in the overall energy mix is unlikely to reduce the effects of price uncertainty, if the overall percentage of fossil fuels remains constant. To reduce the overall exposure to volatility, it is necessary to increase the elements of lower price volatility in energy generating portfolios. In this sense, the main alternatives to fossil fuels (nuclear and renewable energies), both classify as ‘low volatility’ assets, as they are sourced independently of volatile global fossil markets (i.e. domestically). While this study focuses on renewable energies, nuclear energy is also argued to be an important carbon-free source of energy with various benefits such as being non-location specific and scalable (see Kessides, 2010, for an evaluation).

||**Correlation of**<br>Coal|**Fossil Fuels**<br>N.Gas|Cr. Oil||
|---|---|---|---|---|
|Coal<br>N. Gas|1|0.899<br>1|0.909<br>0.864|**Table 8.**Correlation between monthly prices of Coal, Natural Gas and|
|Cr. Oil|||1|Crude Oil from 1983-2011 (Source: IMF Int. Financial Statistics)|

Another useful special case to consider in this context is Iceland: Similar to the previous example of Norway it has large share of renewable energy (73%), and meets its energy needs largely through geothermal power. However, while Norway relies heavily on revenues from oil exports, Iceland’s trading activities with crude oil are insignificant. Thus, Iceland has little exposure to global oil price fluctuations and is largely de-coupled from global oil markets. Indeed, for Iceland the null hypothesis Η _′_ 0:“ _RV does not Granger Cause IP”_ cannot be rejected at 5% (nor 10%) significance – hence oil price volatility cannot be confirmed to have a causal effect on industrial production. Furthermore, in a vector autoregressive setting lagged realized volatility is found to have no significant explanatory power for current industrial production. This suggests that Iceland may have successfully reduced its sensitivity to oil price volatility by increasing the low-variance, renewable share in the generating portfolio.

In practice the above discussion of determinants of sensitivity is by no means exhaustive. Depending on country circumstances, further factors, such as labor market regulation or monetary policy (Blanchard and Gali, 2007), may also play a significant role in determining sensitivity. Similarly, in specific countries the structure of energy provision, price determination or subsidies is also likely to have a significant influence on the link between oil price volatility, uncertainty and economic growth. Nevertheless it is evident that the standard argument of simply considering net importer/exporter status is not sufficient for understanding the level of sensitivity, and that country-specific transmission channels of oil price volatility need to be investigated.

# **5. Simulating Volatility Shocks in ‘Greener’ Energy Portfolios**

Using estimated elasticities and percentage shares of the energy mix, we illustrate the effect of an oil price volatility shock in scenarios with different levels of renewable energy deployment. For this purpose the 2008 spike in oil price volatility is considered: Table 9 presents the effects of the realized volatility increase from 2008m01 to 2008m12 for the given sample. Column ΔRV indicates by which factor the domestic realized volatility measure increased in this period. Based on the accumulated IRF the total percentage effect on economic activity is given under TERV(%). The corresponding economic loss, based on 2008 annual GDP figures is given in the ‘$-Loss’ column. It is evident that the 2008 increase in oil price volatility has caused large GDP losses in all sample countries. Could such losses have been avoided if the renewable energy shares in generating portfolios had been larger?

> 11 In the sample fossil fuels constitute between 62.4% (S. Korea) and 96.6% (Malaysia) of energy <u>portfolios.</u>

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