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The Endogenous Price Dynamics of the Emission Allowances: An Application to CO2 Option Pricing

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  • Marc Chesney

    (University of Zurich and Swiss Finance Institute)

  • Luca Taschini

    (University of Zurich)

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    Abstract

    Market mechanisms are increasingly being used as a tool for allocating somewhat scarce but unpriced rights and resources, such as air and water. Tradable permits have emerged as the most cost–effective measure leading to the emergence of both nationwide (SO2) and supranational (CO2) emission permits markets. By means of the dynamic optimization of companies which are covered by such environmental regulations, we develop an endogenous model for the emission permit spot price dynamics that also accounts for the presence of asymmetric information. In the model, the companies are characterized by exogenous pollution processes that, in the short term, are the underlying of the permit price dynamics. An extensive numerical exercise is carried out for the CO2 permit price in the European market. We introduce for the first-time in the current literature a CO2 option pricing model comparison. The option pricing method can be used for hedging purposes and for pricing CO2-linked projects and investments.

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    Bibliographic Info

    Paper provided by Swiss Finance Institute in its series Swiss Finance Institute Research Paper Series with number 08-01.

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    Length: 42 pages
    Date of creation: Jan 2008
    Date of revision: Jan 2008
    Handle: RePEc:chf:rpseri:rp0802

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    Web page: http://www.SwissFinanceInstitute.ch
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    Related research

    Keywords: Asymmetric Information; Emission Allowances; Endogenous Price Dynamics; Environmental Finance.;

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    References

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    1. Daskalakis, George & Psychoyios, Dimitris & Markellos, Raphael N., 2009. "Modeling CO2 emission allowance prices and derivatives: Evidence from the European trading scheme," Journal of Banking & Finance, Elsevier, vol. 33(7), pages 1230-1241, July.
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    3. Margaret Insley, 2003. "On the option to invest in pollution control under a regime of tradable emissions allowances," Canadian Journal of Economics, Canadian Economics Association, vol. 36(4), pages 860-883, November.
    4. Schennach, Susanne M., 2000. "The Economics of Pollution Permit Banking in the Context of Title IV of the 1990 Clean Air Act Amendments," Journal of Environmental Economics and Management, Elsevier, vol. 40(3), pages 189-210, November.
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    7. Hidalgo, Ignacio & Szabo, Laszlo & Carlos Ciscar, Juan & Soria, Antonio, 2005. "Technological prospects and CO2 emission trading analyses in the iron and steel industry: A global model," Energy, Elsevier, vol. 30(5), pages 583-610.
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    Citations

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    Cited by:
    1. Georg Grüll & Luca Taschini, 2010. "Cap-and-trade properties under different hybrid scheme designs," LSE Research Online Documents on Economics 37597, London School of Economics and Political Science, LSE Library.
    2. Sebastian Goers & Alexander Wagner & Jürgen Wegmayr, 2010. "New and old market-based instruments for climate change policy," Environmental Economics and Policy Studies, Society for Environmental Economics and Policy Studies - SEEPS, vol. 12(1), pages 1-30, June.
    3. Chevallier, Julien & Le Pen, Yannick & Sévi, Benoît, 2011. "Options introduction and volatility in the EU ETS," Economics Papers from University Paris Dauphine 123456789/6793, Paris Dauphine University.
    4. Rene Carmona & Francois Delarue & Gilles-Edouard Espinosa & Nizar Touzi, 2012. "Singular Forward-Backward Stochastic Differential Equations and Emissions Derivatives," Papers 1210.5773, arXiv.org.
    5. Beat Hintermann, 2009. "Allowance Price Drivers in the First Phase of the EU ETS," CEPE Working paper series 09-63, CEPE Center for Energy Policy and Economics, ETH Zurich.
    6. Pauline Barrieu & Max Fehr, 2011. "Integrated EUA and CER price modeling and application for spread option pricing," LSE Research Online Documents on Economics 37576, London School of Economics and Political Science, LSE Library.
    7. Juri Hinz & Alex Novikov, 2010. "On fair pricing of emission-related derivatives," Papers 1011.5792, arXiv.org.
    8. Marc Gronwald & Janina Ketterer & Stefan Trück, 2011. "The Dependence Structure between Carbon Emission Allowances and Financial Markets - A Copula Analysis," CESifo Working Paper Series 3418, CESifo Group Munich.
    9. Blyth, William & Bunn, Derek & Kettunen, Janne & Wilson, Tom, 2009. "Policy interactions, risk and price formation in carbon markets," Energy Policy, Elsevier, vol. 37(12), pages 5192-5207, December.
    10. Chevallier, Julien & Ielpo, Florian & Mercier, Ludovic, 2009. "Risk aversion and institutional information disclosure on the European carbon market: A case-study of the 2006 compliance event," Energy Policy, Elsevier, vol. 37(1), pages 15-28, January.
    11. Luca Taschini, 2010. "Environmental economics and modeling marketable permits," LSE Research Online Documents on Economics 37596, London School of Economics and Political Science, LSE Library.
    12. Juri Hinz & Alex Novikov, 2009. "On Fair Pricing of Emission-Related Derivatives," Research Paper Series 257, Quantitative Finance Research Centre, University of Technology, Sydney.
    13. Georg Grüll & Luca Taschini, 2010. "A comparison of reduced-form permit price models and their empirical performances," LSE Research Online Documents on Economics 37603, London School of Economics and Political Science, LSE Library.
    14. Marc Chesney & Luca Taschini & Mei Wang, 2011. "Regulated and non-regulated companies, technology adoption in experimental markets for emission permits, and options contracts," LSE Research Online Documents on Economics 37577, London School of Economics and Political Science, LSE Library.
    15. Blyth, William & Bunn, Derek, 2011. "Coevolution of policy, market and technical price risks in the EU ETS," Energy Policy, Elsevier, vol. 39(8), pages 4578-4593, August.

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