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Risk Aversion in Modeling of Cap-and-Trade Mechanisms and Optimal Design of Emission Markets


  • Paolo Falbo

    (Department of Economics and Management, University of Brescia)

  • Juri Hinz

    (School of Mathematical Sciences, UTS Business School, University of Technology Sydney)

  • Cristian Pelizzari

    (Department of Economics and Management, University of Brescia)


According to theoretical arguments, a properly designed emission trading system should help reaching pollution reduction at low social burden. Based on the theoretical work of environmental economists, cap-and-trade systems are put into operations all over the world. However, the practice from emissions trading yields a real stress test for the underlying theory and reveals a number of its weak points. This paper aims to fill the gap between general welfare concepts underlying understanding of liberalized market and specific issues of real-world emission market operation. In our work, we present a novel technique to analyze emission market equilibrium in order to address diverse questions in the setting of risk-averse market players. Our contribution significantly upgrades all existing models in this field, which neglect risk-aversion aspects at the cost of having a wide range of singularities in their conclusions, now resolved in our approach. Furthermore, we show how the architecture of an environmental market can be optimized under the realistic assumption of risk-aversion and which approximations must be met therefore.

Suggested Citation

  • Paolo Falbo & Juri Hinz & Cristian Pelizzari, 2015. "Risk Aversion in Modeling of Cap-and-Trade Mechanisms and Optimal Design of Emission Markets," Research Paper Series 359, Quantitative Finance Research Centre, University of Technology, Sydney.
  • Handle: RePEc:uts:rpaper:359

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    emission trading; environmental finance; market equilibrium;
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