Empirical Performance of Reduced-Form Models for Emission Permit Prices
38 Pages Posted: 23 Jul 2013 Last revised: 29 Sep 2016
Date Written: June 2, 2016
The design of environmental trading systems induces specific features of the emission permit price dynamics. In this paper, we evaluate the performance of reduced-form models for emission markets that capture these features in a simplified way and are still feasible for calibration to permit spot, futures, and option prices. Using market data from the European Union Emissions Trading System as the world's largest environmental market, we show that appropriately specified reduced-form models outperform standard approaches with respect to both the historical fit to futures prices and the option pricing performance. Moreover, the performance of reduced-form models critically depends on their consistency with the design of the emission trading system.
Keywords: emission permits, price dynamics, option pricing, environmental finance, carbon derivatives
JEL Classification: G13, Q56, C65, C02
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