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The Endogenous Price Dynamics of Emission Allowances and an Application to CO 2 Option Pricing

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  • Marc Chesney
  • Luca Taschini
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    Abstract

    Market mechanisms are increasingly being used as a tool for allocating somewhat scarce but unpriced rights and resources, and the European Emission Trading Scheme is an example. By means of dynamic optimization in the contest of firms covered by such environmental regulations, this article generates endogenously the price dynamics of emission permits under asymmetric information, allowing inter-temporal banking and borrowing. In the market, there are a finite number of firms and each firm's pollution emission follows an exogenously given stochastic process. We prove the discounted permit price is a martingale with respect to the relevant filtration. The model is solved numerically. Finally, a closed-form pricing formula for European-style options is derived.

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    File URL: http://hdl.handle.net/10.1080/1350486X.2011.639948
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    Bibliographic Info

    Article provided by Taylor & Francis Journals in its journal Applied Mathematical Finance.

    Volume (Year): 19 (2012)
    Issue (Month): 5 (November)
    Pages: 447-475

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    Handle: RePEc:taf:apmtfi:v:19:y:2012:i:5:p:447-475

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    Cited by:
    1. Luca Taschini & Marc Chesney & Mei Wang, 2014. "Experimental comparison between markets on dynamic permit trading and investment in irreversible abatement with and without non-regulated companies," Journal of Regulatory Economics, Springer, vol. 46(1), pages 23-50, August.

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