The Endogenous Price Dynamics of Emission Allowances and an Application to CO2 Option Pricing

34 Pages Posted: 4 Feb 2008 Last revised: 12 Oct 2013

See all articles by Marc Chesney

Marc Chesney

University of Zurich - Department of Banking and Finance

Luca Taschini

London School of Economics & Political Science (LSE) - Grantham Research Institute on Climate Change and the Environment; University of Verona - Department of Economics

Date Written: June 17, 2011

Abstract

Market mechanisms are increasingly being used as a tool for allocating somewhat scarce but unpriced rights and resources, and the European Emission Trading Scheme is an example. By means of dynamic optimization in the contest of firms covered by such environmental regulations, this paper generates endogenously the price dynamics of emission permits under asymmetric information, allowing inter-temporal banking and borrowing. In the market there are a finite number of firms and each firm’s pollution emission follows an exogenously given stochastic process. We prove the discounted permit price is a martingale with respect to the relevant filtration. The model is solved numerically. Finally, a closed-form pricing formula for European-style options is derived.

Keywords: Asymmetric Information, Environmental Finance, European Emission Trading, Scheme, Trading Decisions

JEL Classification: C61, C63, C65, G13

Suggested Citation

Chesney, Marc and Taschini, Luca, The Endogenous Price Dynamics of Emission Allowances and an Application to CO2 Option Pricing (June 17, 2011). Applied Mathematical Finance, Vol. 19, No. 5, 2012; Swiss Finance Institute Research Paper No. 08-02; EFA 2008 Athens Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1090150 or http://dx.doi.org/10.2139/ssrn.1090150

Marc Chesney

University of Zurich - Department of Banking and Finance ( email )

Rämistrasse 71
Zürich, CH-8006
Switzerland

HOME PAGE: http://https://www.bf.uzh.ch/en/persons/chesney-marc

Luca Taschini (Contact Author)

London School of Economics & Political Science (LSE) - Grantham Research Institute on Climate Change and the Environment ( email )

Houghton Street
London, WC2A 2AE
Great Britain

University of Verona - Department of Economics ( email )

Via Cantarane 24
Verona, Verona 37129
Italy

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