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The Role of Hedging in Carbon Markets

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  • Anne Schopp
  • Karsten Neuhoff

Abstract

In the European Emissions Trading System, power generators hold CO2 allowances to hedge for future power sales. First, we model their aggregate hedging demand in response to changes in expectations of future fuel, carbon and power prices from forward prices. This partial equilibrium analysis is then integrated into a two period model of the supply and demand of CO2 allowances considering also emissions impact and banking of allowances by speculative investors. We find that hedging flexibility can balance a CO2 allowance surplus in the range of 1.1 - 1.6 billion t CO2 at discount rates of future carbon allowances between 0 - 10%. If the surplus exceeds this level, then the rate at which today's carbon prices discount expected future prices increases. This points to the value of reducing the surplus estimated to be 2.6 billion t CO2 allowances in 2015 by about 1.3 billion t CO2, thus ensuring that hedging makes a significant contribution to stabilise carbon prices.

Suggested Citation

  • Anne Schopp & Karsten Neuhoff, 2013. "The Role of Hedging in Carbon Markets," Discussion Papers of DIW Berlin 1271, DIW Berlin, German Institute for Economic Research.
  • Handle: RePEc:diw:diwwpp:dp1271
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    References listed on IDEAS

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    1. Backloading – An ineffective economic measure for a good political reason?
      by ? in Bruegel blog on 2013-06-19 13:01:07

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    Cited by:

    1. Richstein, Jörn C. & Chappin, Emile J.L. & de Vries, Laurens J., 2014. "Cross-border electricity market effects due to price caps in an emission trading system: An agent-based approach," Energy Policy, Elsevier, vol. 71(C), pages 139-158.
    2. Fell, Harrison, 2016. "Comparing policies to confront permit over-allocation," Journal of Environmental Economics and Management, Elsevier, vol. 80(C), pages 53-68.
    3. Bocklet, Johanna & Hintermayer, Martin, 2020. "How does the EU ETS reform impact allowance prices? The role of myopia, hedging requirements and the Hotelling rule," EWI Working Papers 2020-1, Energiewirtschaftliches Institut an der Universitaet zu Koeln (EWI).
    4. Lucia, Julio J. & Mansanet-Bataller, Maria & Pardo, Ángel, 2015. "Speculative and hedging activities in the European carbon market," Energy Policy, Elsevier, vol. 82(C), pages 342-351.
    5. Hu, Jing & Crijns-Graus, Wina & Lam, Long & Gilbert, Alyssa, 2015. "Ex-ante evaluation of EU ETS during 2013–2030: EU-internal abatement," Energy Policy, Elsevier, vol. 77(C), pages 152-163.
    6. Richstein, Jörn C. & Chappin, Émile J.L. & de Vries, Laurens J., 2015. "The market (in-)stability reserve for EU carbon emission trading: Why it might fail and how to improve it," Utilities Policy, Elsevier, vol. 35(C), pages 1-18.
    7. Johanna Bocklet & Martin Hintermayer, 2020. "How Does the EU ETS Reform Impact Allowance Prices? The Role of Myopia, Hedging Requirements and the Hotelling Rule," CESifo Working Paper Series 8579, CESifo.
    8. Krasovskii, Andrey & Khabarov, Nikolay & Obersteiner, Michael, 2016. "Fair pricing of REDD-based emission offsets under risk preferences and benefit-sharing," Energy Policy, Elsevier, vol. 96(C), pages 193-205.
    9. Bocklet, Johanna, 2020. "The Reformed EU ETS in Times of Economic Crises: the Case of the COVID-19 Pandemic," EWI Working Papers 2020-10, Energiewirtschaftliches Institut an der Universitaet zu Koeln (EWI).

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    More about this item

    Keywords

    Emissions trading schemes; banking; power hedging; discount rates;
    All these keywords.

    JEL classification:

    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • Q48 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Energy - - - Government Policy

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