Cap and Trade with Imperfect Hedging

Bruno Biais, Johan Hombert, Daniel Schmidt and Pierre-Olivier Weill
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Bruno Biais: HEC Paris
Johan Hombert: HEC Paris - Finance Department
Daniel Schmidt: HEC Paris - Finance Department
Pierre-Olivier Weill: University of California, Los Angeles; National Bureau of Economic Research (NBER)

No 1574, HEC Research Papers Series from HEC Paris

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.

Keywords: emission trading system; carbon pricing; financial constraints; limited commitment; social cost of carbon; Pareto optimality; Incentive compatibility (search for similar items in EconPapers)
JEL-codes: G10 (search for similar items in EconPapers)
Pages: 53 pages
Date: 2025-06-23
New Economics Papers: this item is included in nep-ene and nep-env
Note: We thank Richard Bateman for excellent research assistance.
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Persistent link: https://EconPapers.repec.org/RePEc:ebg:heccah:1574

DOI: 10.2139/ssrn.5308210

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