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An Options Pricing Approach for CO2 Allowances in the EU ETS

  • Beat Hintermann

    ()

    (Center for Energy Policy and Economics CEPE, Department of Management, Technology and Economics, ETH Zurich, Switzerland)

If firms are unable to fully control their emissions, the cap in a permit market may be exceeded. Using stochastic aggregate emissions as the underlying I derive an options pricing formula that expresses the permit price as a function of the penalty for noncompliance and the probability of a binding cap. I apply my model to the EU ETS, where rapid market setup made it difficult for firms to adjust their production technology in time for phase 1. The model fits the data well, implying that the permit price was driven by firms hedging against stochastic emissions rather than marginal abatement costs.

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File URL: http://www.cepe.ethz.ch/publications/workingPapers/CEPE_WP64.pdf
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Paper provided by CEPE Center for Energy Policy and Economics, ETH Zurich in its series CEPE Working paper series with number 09-64.

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Length: 38 pages
Date of creation: Jun 2009
Date of revision:
Handle: RePEc:cee:wpcepe:09-64
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  1. 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.
  2. 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.
  3. Zhao, Jinhua, 2003. "Irreversible Abatement Investment Under Cost Uncertainties: Tradable Emission Permits and Emissions Charges," Staff General Research Papers 10223, Iowa State University, Department of Economics.
  4. Alberola, Emilie & Chevallier, Julien & Cheze, Benoi^t, 2008. "Price drivers and structural breaks in European carbon prices 2005-2007," Energy Policy, Elsevier, vol. 36(2), pages 787-797, February.
  5. Benz, Eva & Trück, Stefan, 2009. "Modeling the price dynamics of CO2 emission allowances," Energy Economics, Elsevier, vol. 31(1), pages 4-15, January.
  6. Wilfried Rickels & Vicki Duscha & Andreas Keller & Sonja Peterson, 2007. "The determinants of allowance prices in the European Emissions Trading Scheme - Can we expect an efficient allowance market 2008?," Kiel Working Papers 1387, Kiel Institute for the World Economy.
  7. Böhringer, Christoph & Lange, Andreas, 2003. "On the Design of Optimal Grandfathering Schemes for Emission Allowances," ZEW Discussion Papers 03-08, ZEW - Zentrum für Europäische Wirtschaftsforschung / Center for European Economic Research.
  8. Pizer, William & Newell, Richard & Zhang, Jiangfeng, 2003. "Managing Permit Markets to Stabilize Prices," Discussion Papers dp-03-34, Resources For the Future.
  9. Seifert, Jan & Uhrig-Homburg, Marliese & Wagner, Michael, 2008. "Dynamic behavior of CO2 spot prices," Journal of Environmental Economics and Management, Elsevier, vol. 56(2), pages 180-194, September.
  10. Montgomery, W. David, 1972. "Markets in licenses and efficient pollution control programs," Journal of Economic Theory, Elsevier, vol. 5(3), pages 395-418, December.
  11. Cronshaw, Mark B & Brown-Kruse, Jamie, 1996. "Regulated Firms in Pollution Permit Markets with Banking," Journal of Regulatory Economics, Springer, vol. 9(2), pages 179-89, March.
  12. Rubin, Jonathan D., 1996. "A Model of Intertemporal Emission Trading, Banking, and Borrowing," Journal of Environmental Economics and Management, Elsevier, vol. 31(3), pages 269-286, November.
  13. Maria Mansanet-Bataller & Angel Pardo & Enric Valor, 2007. "CO2 Prices, Energy and Weather," The Energy Journal, International Association for Energy Economics, vol. 0(Number 3), pages 73-92.
  14. Jos Sijm & Karsten Neuhoff & Yihsu Chen, 2006. "CO 2 cost pass-through and windfall profits in the power sector," Climate Policy, Taylor & Francis Journals, vol. 6(1), pages 49-72, January.
  15. Peter Alaton & Boualem Djehiche & David Stillberger, 2002. "On modelling and pricing weather derivatives," Applied Mathematical Finance, Taylor & Francis Journals, vol. 9(1), pages 1-20.
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