Market-Consistent Modeling for Cap-and-Trade Schemes and Application to Option Pricing

Pauline Barrieu () and Max Fehr ()
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Pauline Barrieu: Statistics Department and Centre for the Analysis of Time Series, London School of Economics, London WC2A 2AE, United Kingdom
Max Fehr: Statistics Department and Centre for the Analysis of Time Series, London School of Economics, London WC2A 2AE, United Kingdom

Operations Research, 2014, vol. 62, issue 2, 234-249

Abstract: In this paper we refer to the requirement for industrialized countries to reach a domestic target for greenhouse emissions, as ratified in the Kyoto Protocol, and propose a market-consistent model of futures price dynamics for cap-and-trade schemes designed in the spirit of the European Union Emissions Trading Scheme (EU ETS). Historical price dynamics for the EU ETS suggest that both European emission allowance (EUA) and certified emission reduction (CER) certificates, generated by a nondomestic offset mechanism, are significantly related. We use an equilibrium framework to demonstrate that compliance regulation singles out special price dynamics. Based on this result, we propose an arbitrage-free model and apply it to the pricing of spread options between EUAs and CERs.

Keywords: environment; asset pricing; stochastic model applications; Markov processes; economics (search for similar items in EconPapers)
Date: 2014
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Citations: View citations in EconPapers (13)

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