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

Author

Listed:
  • Marc Chesney

    (University of Zurich and Swiss Finance Institute)

  • Luca Taschini

    (University of Zurich)

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.

Suggested Citation

  • Marc Chesney & Luca Taschini, 2008. "The Endogenous Price Dynamics of the Emission Allowances: An Application to CO2 Option Pricing," Swiss Finance Institute Research Paper Series 08-01, Swiss Finance Institute, revised Jan 2008.
  • Handle: RePEc:chf:rpseri:rp0802
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    References listed on IDEAS

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    Cited by:

    1. 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.
    2. Georg Grüll & Luca Taschini, 2009. "A Comparison of Reduced-Form Permit Price Models and their Empirical Performances," Working Papers 0918, Massachusetts Institute of Technology, Center for Energy and Environmental Policy Research.
    3. 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.
    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. 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.
    6. Juri Hinz & Alex Novikov, 2009. "On Fair Pricing of Emission-Related Derivatives," Research Paper Series 257, Quantitative Finance Research Centre, University of Technology, Sydney.
    7. Levihn, Fabian, 2014. "CO2 emissions accounting: Whether, how, and when different allocation methods should be used," Energy, Elsevier, vol. 68(C), pages 811-818.
    8. Chesney, Marc & Taschini, Luca & Wang, Mei, 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.
    9. Grüll, Georg & Taschini, Luca, 2011. "Cap-and-trade properties under different hybrid scheme designs," Journal of Environmental Economics and Management, Elsevier, vol. 61(1), pages 107-118, January.
    10. Xu, Li & Deng, Shi-Jie & Thomas, Valerie M., 2016. "Carbon emission permit price volatility reduction through financial options," Energy Economics, Elsevier, vol. 53(C), pages 248-260.
    11. Sebastian Goers & Alexander Wagner & Jürgen Wegmayr, 2010. "New and old market-based instruments for climate change policy," Environmental Economics and Policy Studies, Springer;Society for Environmental Economics and Policy Studies - SEEPS, vol. 12(1), pages 1-30, June.
    12. Chevallier, Julien & Le Pen, Yannick & Sévi, Benoît, 2011. "Options introduction and volatility in the EU ETS," Resource and Energy Economics, Elsevier, vol. 33(4), pages 855-880.
    13. Beat Hintermann, 2009. "An Options Pricing Approach for CO2 Allowances in the EU ETS," CEPE Working paper series 09-64, CEPE Center for Energy Policy and Economics, ETH Zurich.
    14. Luca Taschini, 2010. "Environmental Economics and Modeling Marketable Permits," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 17(4), pages 325-343, December.
    15. Hintermann, Beat, 2010. "Allowance price drivers in the first phase of the EU ETS," Journal of Environmental Economics and Management, Elsevier, vol. 59(1), pages 43-56, January.
    16. repec:eee:rensus:v:79:y:2017:i:c:p:1-8 is not listed on IDEAS
    17. 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.
    18. Barrieu, Pauline & Fehr, Max, 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.
    19. 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.

    More about this item

    Keywords

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

    JEL classification:

    • C02 - Mathematical and Quantitative Methods - - General - - - Mathematical Economics
    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • C65 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Miscellaneous Mathematical Tools
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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