Equilibrium Price Dynamics of Emission Permits

Abstract

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.

Keywords: emission permits, spot and futures price dynamics, carbon derivatives

JEL Classification: G13, Q56, Q58, C61