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Risk-Neutral Pricing of Financial Instruments in Emission Markets: A Structural Approach

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  • Sam Howison
  • Daniel Schwarz

Abstract

We present a novel approach to the pricing of financial instruments in emission markets, for example, the EU ETS. The proposed structural model is positioned between existing complex full equilibrium models and pure reduced form models. Using an exogenously specified demand for a polluting good it gives a causal explanation for the accumulation of CO2 emissions and takes into account the feedback effect from the cost of carbon to the rate at which the market emits CO2. We derive a forward-backward stochastic differential equation for the price process of the allowance certificate and solve the associated semilinear partial differential equation numerically. We also show that derivatives written on the allowance certificate satisfy a linear partial differential equation. The model is extended to emission markets with multiple compliance periods and we analyse the impact different intertemporal connecting mechanisms, such as borrowing, banking and withdrawal, have on the allowance price.

Suggested Citation

  • Sam Howison & Daniel Schwarz, 2010. "Risk-Neutral Pricing of Financial Instruments in Emission Markets: A Structural Approach," Papers 1011.3736, arXiv.org, revised May 2015.
    • Handle: RePEc:arx:papers:1011.3736
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    References listed on IDEAS

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    1. M. T. Barlow, 2002. "A Diffusion Model For Electricity Prices," Mathematical Finance, Wiley Blackwell, vol. 12(4), pages 287-298, October.
    2. Juri Hinz & Alex Novikov, 2009. "On Fair Pricing of Emission-Related Derivatives," Research Paper Series 257, Quantitative Finance Research Centre, University of Technology, Sydney.
    3. René Aïd & Luciano Campi & Adrien Nguyen Huu & Nizar Touzi, 2009. "A Structural Risk-Neutral Model Of Electricity Prices," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 12(07), pages 925-947.
    4. Akira Maeda, 2004. "Impact of banking and forward contracts on tradable permit markets," Environmental Economics and Policy Studies, Springer;Society for Environmental Economics and Policy Studies - SEEPS, vol. 6(2), pages 81-102, June.
    5. Paul Leiby & Jonathan Rubin, 2001. "Intertemporal Permit Trading for the Control of Greenhouse Gas Emissions," Environmental & Resource Economics, Springer;European Association of Environmental and Resource Economists, vol. 19(3), pages 229-256, July.
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    1. Baamonde-Seoane, María A. & Carmen Calvo-Garrido, María del & Coulon, Michael & Vázquez, Carlos, 2021. "Numerical solution of a nonlinear PDE model for pricing Renewable Energy Certificates (RECs)," Applied Mathematics and Computation, Elsevier, vol. 404(C).

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