The Pricing of Carbon Bonds and Other Index-Linked Carbon Derivatives
16 Pages Posted: 20 Feb 2011 Last revised: 25 May 2014
Date Written: April 2011
Dealing with a new topic around the climate change finance, we present the carbon market and its mechanism, focussing on the link between the EUA and the CER markets as well as explaining the challenges of carbon regulation and the economy of primary and secondary CERs. Assuming polluting companies dynamically adjust their emission portfolio allocation based on their accumulated pollution processes, we postulate that in Phase II and consecutive compliance periods with banking and borrowing allowed, agents should always comply to regulation, resulting in positive permit prices bounded by the penalty level.
We then consider a tractable market model for Emission Allowances (EUA) consistent with these features, select a particular growth rates for the CO2 spot price process, and compute their corresponding dynamics. By regulation, the EUA and Certified Emission Reduction (CER) being linked together at the end of the compliance period, we express the dynamics of the CER as a function of the EUA and compute in a simple way a Carbon Bond and other index-linked carbon derivatives.
Keywords: Carbon Trading, Carbon Bond, Index-Linked Carbon Derivatives, Penalty Costs, Risk Premia, Arbitrage Opportunities
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