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Risk-Neutral Pricing of Financial Instruments in Emission Markets: A Structural Approach

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  • Sam Howison
  • Daniel Schwarz
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    Abstract

    We present a novel approach to the pricing of financial instruments in emission markets, for example, the EU ETS. The proposed structural model is positioned between existing complex full equilibrium models and pure reduced form models. Using an exogenously specified demand for a polluting good it gives a causal explanation for the accumulation of CO2 emissions and takes into account the feedback effect from the cost of carbon to the rate at which the market emits CO2. We derive a forward-backward stochastic differential equation for the price process of the allowance certificate and solve the associated semilinear partial differential equation numerically. We also show that derivatives written on the allowance certificate satisfy a linear partial differential equation. The model is extended to emission markets with multiple compliance periods and we analyse the impact different intertemporal connecting mechanisms, such as borrowing, banking and withdrawal, have on the allowance price.

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    File URL: http://arxiv.org/pdf/1011.3736
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    Paper provided by arXiv.org in its series Papers with number 1011.3736.

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    Date of creation: Nov 2010
    Date of revision: May 2012
    Handle: RePEc:arx:papers:1011.3736

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    Web page: http://arxiv.org/

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    1. Paul Leiby & Jonathan Rubin, 2001. "Intertemporal Permit Trading for the Control of Greenhouse Gas Emissions," Environmental & Resource Economics, European Association of Environmental and Resource Economists, vol. 19(3), pages 229-256, July.
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