Energy-Switching Using Lévy Processes - An Application to Canadian and North American Data

Abstract

The Paris agreement in 2016 marks a global effort to limit the increase in temperature. In that spirit, the Federal Government of Canada introduced a carbon tax to reduce greenhouse gas emissions. The main goal of this paper is to define the correct approach to carbon pricing. Following the method, introduce by Goutte and Chevalier (2015), we define the carbon price as the necessary tax to incite electricity producers to switch from coal to natural gas. The novelty of this paper is that we use this method for Alberta and North America. In addition, we consider the case of switching from natural gas to wind as a potential new approach to carbon pricing. After reviewing the two methods, we model prices under three stochastic procedures: Lévy Normal Inverse Gaussian (NIG), Lévy Normal and Heston model. Finally, we generalize our empirical technique to oil, natural gas and coal individually. The main finding of this article is that the Lévy NIG outperforms the Lévy Normal and Heston as it is able to take into account the jumpy and volatile nature of energy prices.

Keywords: Energy Economics, Stochastic Processes, Carbon Pricing, Renewable Energies, Fossil Fuels, Fuel-Switching

JEL Classification: C15, Q48