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Pricing and hedging in carbon emissions markets

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  • Cetin, Umut
  • Verschuere, Michel

Abstract

We propose a model for trading in emission allowances in the EU Emission Trading Scheme (ETS). Exploiting an arbitrage relationship we derive the spot prices of carbon allowances given a forward contract whose price is exogenous to the model. The modeling is done under the assumption of no banking of carbon allowances (which is valid during the Phase I of Kyoto protocol), however, we also discuss how the model can be extended when banking of permits is available. We employ results from filtering theory to derive the spot prices of permits and suggest hedging formulas using a local risk minimisation approach. We also consider the effect of intermediate announcements regarding the net position of the ETS zone on the prices and show that the jumps in the prices can be attributed to information release on the net position of the zone. We also provide a brief numerical simulation for the price processes of carbon allowances using our model to show the resemblance to the actual data.

Suggested Citation

  • Cetin, Umut & Verschuere, Michel, 2009. "Pricing and hedging in carbon emissions markets," LSE Research Online Documents on Economics 29321, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:29321
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    File URL: http://eprints.lse.ac.uk/29321/
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    References listed on IDEAS

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    1. Schweizer, Martin, 1991. "Option hedging for semimartingales," Stochastic Processes and their Applications, Elsevier, vol. 37(2), pages 339-363, April.
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    Citations

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    Cited by:

    1. Georg Grüll & Luca Taschini, 2009. "A Comparison of Reduced-Form Permit Price Models and their Empirical Performances," Working Papers 0918, Massachusetts Institute of Technology, Center for Energy and Environmental Policy Research.
    2. repec:ipg:wpaper:2014-565 is not listed on IDEAS
    3. Julien Chevallier & Benoît Sévi, 2014. "On the Stochastic Properties of Carbon Futures Prices," Environmental & Resource Economics, Springer;European Association of Environmental and Resource Economists, vol. 58(1), pages 127-153, May.
    4. Chassagneux Jean-Francois & Chotai Hinesh & Crisan Dan, 2020. "Modelling multi-period carbon markets using singular forward backward SDEs," Papers 2008.09044, arXiv.org.
    5. Chang, Chia-Lin & Mai, Te-Ke & McAleer, Michael, 2019. "Establishing national carbon emission prices for China," Renewable and Sustainable Energy Reviews, Elsevier, vol. 106(C), pages 1-16.
    6. John Hua Fan & Eduardo Roca & Alexandr Akimov, 2010. "Hedging With Futures Contract: Estimation and Performance Evaluation of Optimal Hedge Ratios in the European Union Emissions Trading Scheme," Discussion Papers in Finance finance:201009, Griffith University, Department of Accounting, Finance and Economics.
    7. John Hua Fan & Eduardo Roca & Alexandr Akimov, 2014. "Estimation and performance evaluation of optimal hedge ratios in the carbon market of the European Union Emissions Trading Scheme," Australian Journal of Management, Australian School of Business, vol. 39(1), pages 73-91, February.
    8. Juri Hinz & Alex Novikov, 2009. "On Fair Pricing of Emission-Related Derivatives," Research Paper Series 257, Quantitative Finance Research Centre, University of Technology, Sydney.
    9. Andreas Welling, 2017. "Green Finance: Recent developments, characteristics and important actors," FEMM Working Papers 170002, Otto-von-Guericke University Magdeburg, Faculty of Economics and Management.
    10. Julien Chevallier & Stéphane Goutte, 2014. "The goodness-of-fit of the fuel-switching price using the mean-reverting Lévy jump process," Working Papers 2014-285, Department of Research, Ipag Business School.
    11. Huang, Zhehao & Dong, Hao & Jia, Shuaishuai, 2022. "Equilibrium pricing for carbon emission in response to the target of carbon emission peaking," Energy Economics, Elsevier, vol. 112(C).
    12. Lukas, Elmar & Welling, Andreas, 2014. "Timing and eco(nomic) efficiency of climate-friendly investments in supply chains," European Journal of Operational Research, Elsevier, vol. 233(2), pages 448-457.
    13. Chamorro, José M. & Abadie, Luis M. & de Neufville, Richard & Ilić, Marija, 2012. "Market-based valuation of transmission network expansion. A heuristic application in GB," Energy, Elsevier, vol. 44(1), pages 302-320.
    14. Julien Chevallier & Stéphane Goutte, 2017. "Estimation of Lévy-driven Ornstein–Uhlenbeck processes: application to modeling of $$\hbox {CO}_2$$ CO 2 and fuel-switching," Annals of Operations Research, Springer, vol. 255(1), pages 169-197, August.
    15. Beat Hintermann, 2013. "Market Power in Emission Permit Markets: Theory and Evidence," CESifo Working Paper Series 4447, CESifo.
    16. Beat Hintermann, 2017. "Market Power in Emission Permit Markets: Theory and Evidence from the EU ETS," Environmental & Resource Economics, Springer;European Association of Environmental and Resource Economists, vol. 66(1), pages 89-112, January.

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    More about this item

    Keywords

    CO2 emission allowances; EU ETS; incomplete information; stochastic filtering; minimal martingale measure;
    All these keywords.

    JEL classification:

    • N0 - Economic History - - General
    • F3 - International Economics - - International Finance
    • G3 - Financial Economics - - Corporate Finance and Governance

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