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Cap and Trade with Imperfect Hedging

Author

Listed:
  • Biais, Bruno

    (HEC Paris)

  • Hombert, Johan

    (HEC Paris - Finance Department)

  • Schmidt, Daniel

    (HEC Paris - Finance Department)

  • Weill, Pierre-Olivier

    (University of California, Los Angeles; National Bureau of Economic Research (NBER))

Abstract

In a cap-and-trade system, emitters face transition risk, to the extent that emission caps and permit prices are volatile. We show, theoretically, and empirically for the EU Emissions Trading System, that i) emitters hedge with emission permits futures bought from financials, ii) financial constraints limit hedging, in particular by limiting and delaying emitters' purchases of permits in the spot market, implying iii) permit prices are below the prices of replicating derivatives portfolios. Moreover, we show theoretically that constrained Pareto optima are implemented in equilibrium with cap-and-trade systems, in which the variance of emission caps is set lower than in the unconstrained case.

Suggested Citation

  • Biais, Bruno & Hombert, Johan & Schmidt, Daniel & Weill, Pierre-Olivier, 2025. "Cap and Trade with Imperfect Hedging," HEC Research Papers Series 1574, HEC Paris.
    • Handle: RePEc:ebg:heccah:1574
    DOI: 10.2139/ssrn.5308210
    Note: We thank Richard Bateman for excellent research assistance.
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    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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