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Cap and Trade with Imperfect Hedging

Author

Listed:
  • Bruno Biais

    (HEC Paris - Ecole des Hautes Etudes Commerciales)

  • Johan Hombert

    (HEC Paris - Ecole des Hautes Etudes Commerciales)

  • Daniel Schmidt

    (HEC Paris - Ecole des Hautes Etudes Commerciales)

  • Pierre-Olivier Weill

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

  • Bruno Biais & Johan Hombert & Daniel Schmidt & Pierre-Olivier Weill, 2025. "Cap and Trade with Imperfect Hedging," Working Papers hal-05380449, HAL.
    • Handle: RePEc:hal:wpaper:hal-05380449
    DOI: 10.2139/ssrn.5308210
    as

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