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Risk-Neutral Models for Emission Allowance Prices and Option Valuation

Author

Listed:
  • René Carmona

    (Bendheim Center for Finance, Program in Applied and Computational Mathematics, and Department of Operations Research and Financial Engineering, Princeton University, Princeton, New Jersey 08544)

  • Juri Hinz

    (Department of Mathematics, National University of Singapore, Singapore 119076, Singapore)

Abstract

The existence of mandatory emission trading schemes in Europe and the United States, and the increased liquidity of trading on futures contracts on CO 2 emissions allowances, led naturally to the next step in the development of these markets: These futures contracts are now used as underliers for a vibrant derivative market. In this paper, we give a rigorous analysis of a simple risk-neutral reduced-form model for allowance futures prices, demonstrate its calibration to historical data, and show how to price European call options written on these contracts. This paper was accepted by Haitao Li, guest editor, finance.

Suggested Citation

  • René Carmona & Juri Hinz, 2011. "Risk-Neutral Models for Emission Allowance Prices and Option Valuation," Management Science, INFORMS, vol. 57(8), pages 1453-1468, August.
    • Handle: RePEc:inm:ormnsc:v:57:y:2011:i:8:p:1453-1468
    DOI: 10.1287/mnsc.1110.1358
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    References listed on IDEAS

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    2. Karpf, Andreas & Mandel, Antoine & Battiston, Stefano, 2018. "Price and network dynamics in the European carbon market," Journal of Economic Behavior & Organization, Elsevier, vol. 153(C), pages 103-122.
    3. Jilin Zhang & Yukun Xu, 2020. "Research on the Price Fluctuation and Risk Formation Mechanism of Carbon Emission Rights in China Based on a GARCH Model," Sustainability, MDPI, vol. 12(10), pages 1-11, May.
    4. Lu Wan & Zi-Long Wang & Jhony Choon Yeong Ng, 2016. "Measurement Research on the Decoupling Effect of Industries’ Carbon Emissions—Based on the Equipment Manufacturing Industry in China," Energies, MDPI, vol. 9(11), pages 1-17, November.
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    6. Paolo Falbo & Cristian Pelizzari & Luca Taschini, 2016. "Renewables, allowances markets, and capacity expansion in energy-only markets," GRI Working Papers 246, Grantham Research Institute on Climate Change and the Environment.
    7. Julien Chevallier & Benoît Sévi, 2014. "On the Stochastic Properties of Carbon Futures Prices," Environmental & Resource Economics, Springer;European Association of Environmental and Resource Economists, vol. 58(1), pages 127-153, May.
    8. Chassagneux Jean-Francois & Chotai Hinesh & Crisan Dan, 2020. "Modelling multi-period carbon markets using singular forward backward SDEs," Papers 2008.09044, arXiv.org.
    9. Sheu, Jiuh-Biing, 2014. "Airline ambidextrous competition under an emissions trading scheme – A reference-dependent behavioral perspective," Transportation Research Part B: Methodological, Elsevier, vol. 60(C), pages 115-145.
    10. Julien Chevallier & Stéphane Goutte, 2014. "The goodness-of-fit of the fuel-switching price using the mean-reverting Lévy jump process," Working Papers 2014-285, Department of Research, Ipag Business School.
    11. Huang, Zhehao & Dong, Hao & Jia, Shuaishuai, 2022. "Equilibrium pricing for carbon emission in response to the target of carbon emission peaking," Energy Economics, Elsevier, vol. 112(C).
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    13. Stefan Trück & Rafał Weron, 2016. "Convenience Yields and Risk Premiums in the EU‐ETS—Evidence from the Kyoto Commitment Period," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 36(6), pages 587-611, June.
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    16. Chien-Ming Chen, 2014. "Evaluating eco-efficiency with data envelopment analysis: an analytical reexamination," Annals of Operations Research, Springer, vol. 214(1), pages 49-71, March.
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    18. Julien Chevallier & Stéphane Goutte, 2017. "Estimation of Lévy-driven Ornstein–Uhlenbeck processes: application to modeling of $$\hbox {CO}_2$$ CO 2 and fuel-switching," Annals of Operations Research, Springer, vol. 255(1), pages 169-197, August.
    19. Steffen Hitzemann & Marliese Uhrig-Homburg, 2019. "Empirical performance of reduced-form models for emission permit prices," Review of Derivatives Research, Springer, vol. 22(3), pages 389-418, October.
    20. Ren'e Aid & Sara Biagini, 2021. "Optimal dynamic regulation of carbon emissions market: A variational approach," Papers 2102.12423, arXiv.org.
    21. Han Jun S. & Kordzakhia Nino & Shevchenko Pavel V. & Trück Stefan, 2022. "On correlated measurement errors in the Schwartz–Smith two-factor model," Dependence Modeling, De Gruyter, vol. 10(1), pages 108-122, January.
    22. Carmichael, David G. & Ballouz, Joseph J. & Balatbat, Maria C.A., 2015. "Improving the attractiveness of CDM projects through allowing and incorporating options," Energy Policy, Elsevier, vol. 86(C), pages 784-791.

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