Equilibrium Price Dynamics of Emission Permits
University of Pennsylvania - Finance Department; Karlsruhe Institute of Technology (KIT)
Karlsruhe Institute of Technology (KIT) - Financial Engineering and Derivatives Department
This paper presents a stochastic equilibrium model for environmental markets that allows us to study the characteristic properties of emission permit prices induced by the design of today's cap-and-trade systems. We characterize emission permits as highly nonlinear contingent claims on economy-wide emissions and reveal their hybrid nature between investment and consumption assets. Our model makes predictions about the dynamics and volatility structure of emission permit prices, the futures price curve, and the implications for option pricing in this market. Empirical evidence from existing emissions markets shows that the model explains the stylized facts of emission permit prices and related derivatives.
Number of Pages in PDF File: 47
Keywords: emission permits, spot and futures price dynamics, carbon derivatives
JEL Classification: G13, Q56, Q58, C61
Date posted: February 17, 2011 ; Last revised: November 18, 2014
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